Trading and settling enhancements to the standard electronic futures exchange market model leading to a novel pooled and potentially guaranteed risk deposit market

ABSTRACT

A method allows an interbank deposit market to be created within an adapted electronic futures exchange type market model, rules and legal environment. The basic embodiment allows all participating individual banks to avoid the need to calculate and maintain traditional counterparty credit limits against each other. Another embodiment comprises the basic embodiment plus in addition a guarantee from a lender of last resort such as a central bank which allows a daily liquidity control mechanism similar to the monthly reserve requirement to operate that is the equivalent of futures initial margin.

CROSS-REFERENCE TO RELATED APPLICATION

This patent application is related to and claims benefit of U.S.Provisional Patent Application No. 60/667,878 filed Apr. 1, 2005,entitled “Trading and Settling System” which is incorporated herein inits entirety by reference for all that it teaches without any exclusion.

FIELD OF THE INVENTION

This invention relates to a set of linked methods, system upgrades,computer program products and financial product designs for enablingtrading and settling of new product types on what where hitherto onlyfutures exchanges and their clearing houses.

More particularly, the present invention relates to a method, a system,and a computer program product for trading and settling: exchange tradedcredit derivatives, exchange traded interest rate swaps, exchange tradedmoney market derivatives plus other exchange traded structuredderivative contracts and also equivalents of more traditionalnon-derivative debt products e.g. deposits etc.

BACKGROUND TO THE INVENTION Broad Context of the Invention The EvolvingLandscape for Financial Risk

This section comments on the advantages of financial futures exchangesput inside the context of the evolving landscape for financial risk. Thefinancial risk content relies heavily on extracts from a speech byMalcolm Knight, the General Manager of the Bank for InternationalSettlements (BIS). The BIS is an international organisation whichfosters international monetary and financial cooperation and serves as abank for central banks:

The financial system has undergone a profound transformation over thepast three decades, driven by the combined impact of liberalisation andtechnological innovation. This in turn has driven a significanttransformation in the nature of financial risk. The industry has gainedenormously in richness, depth and variety. The large number of newderivative financial instruments that have developed, partly in the wakeof breakthroughs in pricing theory and advances in computingtechnologies, attest to this transformation.

The size of the financial sphere of developed economies has increasedtremendously along different dimensions but above all in terms ofturnover. It is well known that monthly global turnover in the mainasset classes far exceeds yearly global GDP. Within financial services,traded instruments have greatly outgrown traditional non-traded ones,such as loans or deposits. On the one hand, we have witnessed abroadening of the range of players engaged in the same type of financialactivity. And on the other hand, the surge in cross-border activity hasheightened the role of non-residents in domestic markets in manycountries.

In line with growth in turnover, the management of financial risk hasbecome a more important aspect of economic activity. This also meansthat problems in the financial system, if and when they emerge, can havelarger consequences for the real economy than they did in the past. Themessage has been hammered home by the costs of the financial crises thathave occurred in both industrial and emerging market countries over thepast two decades. Not surprisingly, addressing financial instability hasbecome a major policy concern, both nationally and internationally.

By contrast over the same period the appearance of financial futures andoptions exchanges have been welcomed by policy makers and regulators.These trading venues have the virtue of transparency and relativesimplicity. They have also shown extreme robustness to stress forexample during the Barings bank collapse. Unfortunately the growth ofnew derivative financial instruments both in terms of variety andturnover has mostly happened away from exchanges in the so called OverThe Counter (OTC) market.

Unfortunately in this modern environment, financial risk has become morecomplex. In the OTC market derivative instruments that originallytargeted market risk resulted, as a by-product, in a pyramiding ofcounterparty risk that required separate management. This opaquelayering of direct and indirect links through the markets alsoprofoundly complicates the assessment of the true underlying risks. Bycontrast counterparty risk issues do not arise on financial futures andoptions exchanges.

The old analysis of risk that was structured around traditional businesslines has become increasingly irrelevant. In other words, thesimilarities in underlying risks are becoming more apparent, regardlessof the type of financial firm incurring them. The ongoing consolidationin the financial sector is partly driven by the realisation that thesesimilarities can lead to cost saving synergies. In the resulting largefinancial firms, a common capital base underpins on-balance sheetintermediation, capital market services and market-making functions.Globally, the smaller number of very large internationally activefinancial institutions has created potential concentration risks for thefinancial system. This is because losses in one activity can putpressure on the entire firm, affecting its activities in other areas.More fundamentally, what is sometimes referred to as the “endogenous”component of risk could be triggered by a large bank failure. This isthe component that reflects the impact of the collective actions ofmarket participants on the ultimate drivers of risk themselves i.e. theherd effect. The layering and pyramiding of counterparty risk in the OTCderivative market adds to these concerns.

Value Add of the Invention and Basle II

Financial futures and options exchanges contain a small but significantfraction of the liquidity of modern financial markets. These derivativesare superbly designed to manage their users' market risks efficientlyand indeed to largely eliminate systematic operational and counterpartycredit risks. However the exchanges' product ranges have historicallybeen highly constrained to only futures and options. They have thereforeremained at the periphery of the profound transformation of thefinancial system described in the previous section.

The purpose of the invention is to facilitate the overthrow of thetraditional model and move derivatives exchanges firmly into themainstream. Such a move away from the conventional OTC market, wouldrapidly achieve the goals of policy makers such as Malcolm Knight. Thisin turn should be good for economic growth and prosperity as generallyspeaking more efficient financial markets lead to a more efficient realeconomy. The invention should be particularly applicable to emergingmarket economies where both counterparty credit risk and operationalissues have held back the development of efficient financial markets.

Several objectives that at present appear remote dreams of policy makerscan come closer to reality by harnessing the infrastructure of a futuresand options exchange for broader purposes. For example:

-   The general principle that similar risks should be measured and    managed in a similar way across a firm, irrespective of their    location, would largely and automatically be met. This is because an    increasing number of positions would be held at the same exchange    venue and therefore risk margined consistently; and also-   The long-term ideal of a fully integrated treatment of risk, based    on a common metric, would inevitably be met for the same reasons;    and also-   The condition of a financial firm with regard to its risk profile,    would become easier to identify. This is because with all positions    held and risk margined at the same exchange venue the leveraged    value at risk (i.e. initial margin ) would become objectively    measurable for each firm; and indeed-   The treatment of the endogenous component of risk could be    revolutionalised, with improvements in both systematic risk    measurement and systematic risk management made possible for policy    makers.

On the last point it is conceivable that if a dominant central advancedderivatives exchange emerged in each developed economy, then policymakers could gain control of some drivers of the endogenous component ofrisk. With sufficient academic research some equivalents of reserverequirements and reserve policy could be created but applied to theinitial margin held at the exchange's central counterparty rather thanto bank lending. These hypothetical reserve requirements (or “hair cut”rates) would be the equivalent of creating an intelligent dynamicelement in the capital adequacy framework. Policy makers could for thefirst time manipulate the markets' risk appetites directly by raising orlowering the official hair cut rate(s) counter-cyclically. Such anadvanced policy would empower the natural incentive of marketparticipants to instil self discipline indirectly and efficiently,especially when dealer performance is evaluated and rewarded usingrisk-adjusted returns.

Whilst the invention has potential to go a very long way towards meetingthe needs of policy makers and regulators in the longer term, they haveuntil now adopted their own approach.

On 26 Jun. 2004 central bank governors and the heads of bank supervisoryauthorities in the Group of Ten (G10) countries met and endorsed thepublication of the “International Convergence of Capital Measurement andCapital Standards: a Revised Framework”, the new capital adequacyframework commonly known as Basel II. The meeting took place at the Bankfor International Settlements in Basel, Switzerland, one day after theBasel Committee on Banking Supervision, the author of the text, approvedits submission to the governors and supervisors for review.

Nearly all jurisdictions with active banking markets require bankingorganisations to maintain at least a minimum level of capital. Capitalserves as a foundation for a bank's future growth and as a cushionagainst its unexpected losses. Excessively low levels of capitalincrease the risk of bank failures which, in turn, may put depositors'funds at risk. If on the other hand capital levels are too high, banksmay not be able to make the most efficient use of their resources, whichmay constrain their ability to make credit available and hence hurt theeconomy.

The Basel II Framework builds on the first Basel Accord which in 1988created the basic structure for setting capital requirements. It is morereflective of the underlying risks in banking hence improving thecapital framework's sensitivity to the risks that banks actually faceand providing stronger incentives for improved risk management. Theseimprovements will be achieved in part by aligning capital requirementsmore closely to the risk of credit loss and by introducing a new capitalcharge for exposures to the risk of loss caused by operational failures.

The credit risk is the larger part of the Basle II capital charge, andrequires a lot of work to sort out. Getting credit risk wrong can becostly for banks, but over the longer term, getting operational riskwrong can be costlier. In either case there will be stronger incentivesfor trading on organised markets with central clearing than ever before.This can only be good for the uptake of the invention.

A Brief on Financial Markets Before Derivatives

Before financial derivatives existed ‘the financial markets’ could bedefined as the general term covering the separate markets in the debt,foreign exchange and equity traded asset classes. Since the advent offinancial derivatives trading this picture has been both split into newasset classes (e.g. implied volatility, credit etc) and blurred by thegrowth of cross asset products (e.g. forex swaps, convertible bondsetc). In order to understand derivatives fully one most first have agood working knowledge of their underlying (so called ‘cash’ markets)and this is the purpose of this background section.

The Basic Concept of Interest

The current invention is mostly concerned with derivatives of the debtmarkets only. Raising debt (i.e. getting new money) is important. Havingmoney is an advantage as it can be used to buy goods and services.Alternatively consumption can be deferred and the money invested in abusiness either by buying shares or more directly. In either caseinvesting in a business always carries some considerable risk but withthe hope of receiving a risk proportionate positive return on theinvestment. Taken as an average over the whole economy but depending onprevailing conditions such equity investments will tend to grow.

Forgoing both consumption and investment in a business is thus asignificant opportunity cost. Lenders of money to others shouldtherefore be compensated. Traditionally this is done by payment ofinterest on such loans as well as the eventual repayment of principle.The interest charged will differ depending on the currency (henceeconomy) of issuance and also on the term of the loan.

Borrowing and lending is clearly at the very heart of the financialsystem. The level of interest is clearly important to the fair treatmentof creditors but making interest payments and the return of principal isfundamental. The risk of default being triggered will vary with theborrower's circumstances. The consequences of default depend on theseniority, the legal structure and collateralisation or otherwise of thedebt. The debt markets can be broken down according to these and othercriteria. Nonetheless the simple rule is that a borrower perceived tohave a higher risk will have to pay lenders higher interest to attracttheir funds.

Negotiable Securities

There are many ways to raise money differing in interest type charged,source of funds, principal repayment schedule etc. Another significantdifference is that between loan agreements (usual bilateral contracts)and negotiable securities. In the former case the lending party orparties will probably not change during the life of the loan. Negotiablesecurities can also be referred to as “financial paper” as they aredocuments (or merely registry entries) indicating creditor-ship in thecase of debt securities or ownership in the case of equities.

By contrast to loans debt securities are specifically designed toencourage the easy transfer of title. The existence of a secondarymarket make both the borrower to creditor relationship and the risks tolenders different for securities. In addition the accounting and taxtreatment may not be the same for loan agreements and debt securities.The appropriate interest rate required in each market may thereforediffer significantly.

Credit Ratings

A credit rating agency is a firm that provides its opinion on thecreditworthiness of an entity and the debt securities issued by anentity. Several well established agencies exist to assign credit ratingsand often fund managers will be barred from purchasing securities fromissuers below a certain rating. Issuers will pay the agencies to ratetheir company or specific issues. The rating scales are different forshort term and longer term debt and different ratings may applydepending on who the legal borrower is e.g. parent or subsidiary.

When an issuer's credit rating deteriorates the price of its debtsecurities can fall substantially in the secondary market. A worseningperception among investors and the risk of downgrades form part of thecredit risk of a security. An investor can thus still be exposed tocredit risk even if the security he holds does not default.

Different fund managers will be subject to different rules therebysegmenting the investor community. Important sectors are investmentgrade and sub-investment grade (junk) bonds in each major currency. Forexample, a credit rating agency may assign a “triple A” credit rating asits top “investment grade” rating for corporate bonds and a “double B”credit rating or below for “non-investment grade” or “high-yield”corporate bonds. A foreign company's credit rating will typically notexceed that of it's government.

Interest rates are to a large extent determined by supply and demandfactors and these may differ from one investor community to another.Thus in times of crisis emerging market bond price drops can becorrelated across the world despite no obvious link between theparticular national economies concerned. In emerging markets effectivedefault can occur if the local currency is devalued thereby making anybonds denominated in that currency worth much less to outside investors.This kind of credit risk is called country risk.

One final point worth noting is that during total bankruptcy shares andbond prices will obviously become correlated by both tending to zero(ignoring recovery valuations of debt etc). By extension lower ratedcredits will have bonds correlating with their issuers' stock priceseven if there is only a probability of bankruptcy. As a result bear(bull) stock market moves tend to be associated with widening(narrowing) credit spreads.

Money Markets and Capital Markets

Another important way to categorise interest rate products is accordingto their final repayment date, known as their maturity:

-   Debt instruments with less than one year (or occasionally two years)    to go before maturity are part of the so called “short term” or    “money markets”; but-   Debt instruments with more than one year to go before maturity are    part of the so called capital markets.

The distinction is partly due to the different purposes for which loansare typically required. The money markets are a major source (and sink)of funds for cashflow management i.e. corporate treasury operations. Bycontrast the primary capital markets are usually used for raising moneyrequired for investment in a company's business plans and includeequities as well as debt. A debt security issued into the money marketsis generally known as a “bill” whilst a debt security issued into thecapital markets is often referred to as a “note” or “bond”.

An additional distinction between money markets and capital markets isthe role of the central banks. Central banks actively manage and seek todominate supply and demand in the short term rate environment of theirrespective currencies. They do so in an attempt to control economicactivity. The bond markets on the other hand are freer to find their ownlevel occasionally frustrating central bank short rate moves by shiftingin the opposite direction.

Annualised Interest and Day Count Conventions

For ease of comparison between instruments of different maturity thepercentage by which an investor's money will grow in a single year isoften quoted. This is known as the interest rate. Where an instrumenthas less than one year to go before maturity the percentage growth untilmaturity is “annualised” upward. For example if an investor is quoted 4%per annum when placing funds on deposit in the interbank market for 3months that gives a total return of approximately 1% as there areactually 12 months in a year.

An alternative to quoting annualised interest rates which measure totalreturn of initial money lent is quoting the discount rates on totalmoney due to be paid at maturity. The latter are conventionally used forcertain money market securities. Thus a 3 month T-bill trading at 99.00%of face value at maturity is discounted by 1% of face and hence has adiscount rate of approximately 4% per annum as there are actually 12months in a year.

The exact annualised rate depends on the day counting conventions usedin the relevant market. The US interbank deposit market for example usesan “Actual/360” day count convention which means that a 4.00% interestrate for a 3 months period that turned out to actually be 92 days whencounted, gives a total return of 4%*92/360=˜1.022%. In the financialmarkets transactions tend to be so large that a little bit of confusioncan cause disagreements to arise over substantial amounts of money hencethe importance of day count conventions. In the above example aninvestor depositing $100 million would earn twenty two thousand dollarsmore than would be expected by just counting three months as ¼ of ayear. Getting it right is clearly worth worrying about. Of course thereare various different day count conventions in the many differentmarkets. They are important but are no harder to understand than theexample above.

Money Market Debt Instruments and the Money Market Convention

Amongst securities “T-bills” are of the best credit quality possible andare issued by the treasury department. Other significant money marketsecurities include the “commercial paper” issued by large companiesespecially banks. “Certificates of deposit” which give the holder aright to money already deposited at a bank at whatever interest rate wasnegotiated at the time of issue also exist. “Bills of exchange” and“bank accepted bills of exchange (bankers acceptances)” are used for thefinancing of commerce in commodities or manufactures products and arealso transferable especially the acceptances as they are guaranteed by abank.

In the loan markets, interbank deposits (“depos”) and repurchaseagreements (“repos”) are standardised and very liquid. As well therebeing no doubts surrounding day count convention interbank liquidityresides at certain predetermined points on the maturity curve. Overnight(O/N) lending supplies funds for today to be repaid on the next businessday (T+1), thus overnight will earn at least three days of interestsevery Friday and more if Monday is not a business day. “Tomorrow-next”or “tom-next” (T/N) is simply the next business day's overnight buttraded today. Historically money took time to transfer so all lendingterms are calculated relative not to the trade date but to the so-calledspot date which is simply trade date plus two business days (T+2).

Typically the interbank market will only quote active two way markets atmaturities of a whole number of weeks, months or years i.e. spot plus 1week, spot plus 2 weeks, spot plus 3 weeks, spot plus 1 months, spotplus 2months, spot plus 3months, spot plus 4months, spot plus 5months,spot plus 6months, spot plus 7months, spot plus 8months, spot plus9months, spot plus 10 months, spot plus 11 months, spot plus 1 year etc.There is an accepted and rigidly defined market standard called themoney market convention for these so called on-the-run points, whichdepend on the currency traded (because of national holidays):

-   Business days—A working day in the principal financial centre of the    currency (i.e. New York for US Dollars). In the case of    Euro-Currencies it must also be a working day in London (e.g. a    Euro-Dollar business day must be a business day both in New York and    in London). Business days for    are any days when the TARGET system is running.-   Spot date—Two business days after trade date.-   N-week date—Is N*7 days after the spot date but if this is not a    business day the next business day after that.-   N-month/years date—Is the same calendar day in the month or the    nearest to it as the spot date but N months or years afterwards    (e.g. If spot is 31st March then 1-month later is 30th April). If    this is not a business day the next business day after that applies    unless this takes us into the wrong (i.e. next) month in which case    it's the previous business day that applies

As we shall see the money market convention is also used for certainderivatives.

Longer Term Debt Instruments and Yield

There are many medium and long term debt securities including governmentnotes and bonds, promissory notes, corporate bonds, floating rate bondsetc. Because T-notes and T-bonds carry no credit risk they are by farthe most liquid longer term debt instruments.

Where an instrument has more than one year to go before maturity therelevant annualised interest rate is not easy to compute. Clearly daycount conventions will still come into play but there are othercomplications. Most longer dated debt will pay fixed interest at regularintervals either annually, semi-annually or even monthly not just atmaturity. An intermediate payment for a bond or note is called a couponpayment.

If they were all traded separately the coupons and the principalrepayments could each have a uniquely defined discount rate or interestrate associated with them just as money market securities do. Such zerocoupon bonds do indeed exist and are traded in the market. The relevantformula for calculating the annual rate of return will be slightly morecomplex than for bills to take account of compounding i.e. a notionalannual reinvestment.

Clearly as the secondary market price of the whole bond varies thereturn on investment will vary too even though it may be hard tocompute. Crucially the rate at which the coupons may be reinvested inthe future is unknown beforehand. Consider the case of investorsexpecting a rising reinvestment rate in the near future as an example.In such circumstances a higher coupon bond will become preferable as thesooner the funds are available the sooner they may be reinvested.

A conventional solution uses the same rate to calculate reinvestment asthe return on investment that is itself being calculated. The relevantcalculation is non trivial but can be applied to a bond's market pricewithout reference to any other data, such as reinvestment rates impliedby other instruments in the market. The single assumed return andreinvestment rate when correctly annualised becomes known as the yieldto maturity. The conventional yield in a particular market will dependon the day counts used etc.

Convexity in the Price Versus Yield Relationship

The advantage of yield is that it gives a quick idea of value for money.Bond prices will differ simply because of factors like maturity andcoupon rate. Yet in general the higher the yield of one bond relative toanother the better the relative value offered by that bond, when allelse is equal. Of course yields can be legitimately higher on a bond dueto it's higher risks e.g. lower credit rating etc. The coupon effectalluded to previously should not however be neglected in that if twobonds have the same yield and maturity the higher coupon one may bepreferred in a rising rate environment. Conversely the lower coupon onecan have a slightly higher yield and still not offer best value.

Although yield is non-trivial to calculate it is nonetheless astraightforward indicator of value for money. Better value in thecontext of the secondary market will of course mean cheaper so it ishardly surprising that a price against yield graph for a single bondwill show its price dropping as yield goes up. However since holding thebond represents rights to positive cashflows on future coupon paymentdates and at maturity, the bond's price can never go negative howeverhigh its yield goes. This means that the bond price will drop off moreand more slowly as yield goes up and this effect is referred to as“positive convexity”.

Yield is such a useful concept that traders will often appear moreinterested in it than price especially when switching from one bond intoanother i.e. selling a previous holding to buy a new one. Howevertraders will never lose sight of price because that is what theirprofits and losses are measured in.

Clean Price and Accrued Interest

As stated previously most notes and bonds will pay interest at regularintervals typically annually or semi-annually. In either case from timeto time coupon payments will actually be made. Clearly the value of abond will drop the moment it becomes traded in the secondary marketwithout the coupon attached (known as going “ex-div”). This means thateven at a constant yield the price of a bond will show cyclicalvariations in price with a kind of ‘saw-tooth’ pattern.

These oscillations over time in the price of the bond tend to cloud thesimple relationship between the yield and the quoted price at any onetime. The situation is made more manageable by a market convention thathas been created to make them less prominent. Dealers in the marketplace do not quote the full price when trading in price terms butinstead quote a so-called “clean price”. In this framework the fullprice is known as the “dirty price” and the clean price is the dirtyprice less “accrued interest” which is defined below.

Each day the front coupon should earn the bond holder interest so whenthe bond is traded in the secondary market the buyer must compensate theprevious holder for the fraction of the next coupon payment that isrightfully theirs. This fraction is known as the accrued interest and isproportional to the number of days that have passed since the previouscoupon payment date. Accrued interest must be calculated using therelevant day count convention. Since accrued interest is taken intoaccount the graph of clean price at a constant yield does not show the‘saw-tooth’ pattern of dirty price. Where the bond goes ex-div severaldays before the notional coupon payment or is newly issued with a longfirst coupon period it may trade with negative accrued interest.

The Yield Curve and Credit Spreads

One of the most fundamental concepts of interest rate products is theyield curve. This is sometimes grandly referred to as the term structureof interest rates but in reality it is a simple graph of yield againstmaturity for many different issues of equal credit class. To bemeaningful the yields must all be quoted under the same convention andat the same time (since the curve moves). Coupon effect, tax andliquidity differences notwithstanding the points will form an obviouscurve.

There are higher curves for lower quality credits corresponding to thehigher yields that investors demand. The spreads between the differentcredit curves are closely traded entities in their own right. The riskassociated with a particular borrower is conventionally expressed interms of credit spreads over benchmark (i.e. government bond yields orinterbank swap rates) in both the primary and secondary markets. Anotherway to express risk is typically in terms of credit ratings and thesewill therefore have prevailing credit spreads associated with them foreach type (sector) of issuer. Issuer type is important as credit ratingsgive the risk of default but not the expected recovery rates which arepart of the overall risk and hence credit spread.

However it is spread trading along each credit that maintains the curvestructure. Consider for example supply and demand imbalances making aparticular T-note's yield higher than it's neighbours. If the T-notebecomes cheaper in this way traders will most probably sell theneighbouring T-notes to buy this cheaper one. They will therefore drivethe prices of the neighbouring notes lower and that of the cheapenednote itself higher. In this way the original anomaly in the yield curveis quickly smoothed out. Because the curve maintains its integrity as itmoves interest rate products can be highly correlated across maturities,not just across credit quality and currencies as discussed previously.

The yield curve is important to traders because money can be made frompredicting the shape changes it undergoes and indeed by borrowing andlending at different maturities. It is important to note that rates maymove but with no change in shape of the yield curve. This parallel shiftup or down in the curve is a neutral assumption that is often applied bytraders when setting up their curve related strategies.

Structured Products and Special Purpose Vehicles

Collateralised Debt Obligations (CDOs) are investments collateralised byor referenced to a diverse portfolio of debt rather than other assets(e.g. rents etc).

Asset backed securities including CDOs are generally issued by SpecialPurpose Vehicles (SPVs) or entities set up to allow for the transfer ofrisk from the originator to an entity that is generally thinlycapitalised, bankruptcy-remote and isolated from any credit riskassociated with the originator. To limit the universe of an SPV'spotential creditors, it is usually a newly established entity, with nooperating history that could give rise to prior liabilities. The SPV'sbusiness purpose and activities are limited to only those necessary toeffect the particular transaction for which the SPV has been established(for example, issuing its securities and purchasing and holding itsassets), thereby reducing the likelihood of the SPV incurringpost-closing liabilities that are in addition or unrelated to thoseanticipated by rating agencies and investors.

The costs of the infrastructure and services associated with theestablishment and management of SPVs are part of the context of thisinvention.

CDOs are designed so that investors can directly benefit from thediversification inherent in the underlying portfolio. This underlyingcollateral pool is repackaged so that they have the choice of buyingjunior, mezzanine, senior and super senior segments etc. The exacttiering depends on the deal but typically tranches are defined by twopercentage face value numbers—The lower number known as the attachmentpoint defines the minimum losses to which the investor is exposed whilethe higher number known as the detachment point defines the maximumlosses. An alternative method of tranching is achieved by definingtranches in terms of the defaulting entity i.e. the first to default,second to default tranches etc.

CDO tranches are invariably rated in order to make them saleable tofunds whose rules demand only credit rated assets of certain quality arepurchased i.e. the majority of traditional funds. As tranches areexposed to portfolio losses above and below certain thresholds, eachtranche must carry an attractive coupon relative to its credit ratingsor investors will not buy it. Issuers therefore work closely with creditrating agencies to “ramp-up” the value of each tranche relative to therisk it carries i.e. to package the diversification benefits asattractively as possible.

In summary buying into a CDO can give investors exposure to awell-diversified range of credits, industries, geographical regions orstructures that they may have been unable to access independently. Anadditional attraction of the market for collateralised instruments isthat they generally provide investors with exposure to an asset with lowcorrelation to other securities such as vanilla bonds and equities.Indeed it has been argued that the equity tranches of certain CDOsshould warrant consideration as an alternative asset class (alongsideinvestments such as hedge funds and private equity) for pension funds toconsider. However the principal attraction for investors has been andwill continue to be the greater yield CDOs offer compared to corporateissues with similar credit ratings.

More Detailed Context of the Invention Definition of Derivatives

A derivatives contract can be defined as an agreement between twocounterparties in which rights and obligations are set up whose economicvalue, either by direct reference to a benchmark price quote or byoperation of the contract in its delivery phase, can be derived from oneor more underlying (often called ‘cash’) products. Typically theexposure obtained by entering into a derivatives contract creates theequivalent of a highly leveraged position in the cash underlying so thattraders can gain or lose large amounts of money without putting up largeamounts of actual capital i.e. without being fully funded.

Derivatives on other derivatives can also exist in which case theunderlying is often still called the cash in the appropriate context.Despite the high leverage typical of derivatives there exist certain lowrisk trading strategies which involve taking derivative positions andtheir underlying cash positions together. The strategies can and areemployed to lock in even relatively small pricing anomalies betweenthese related markets whenever they arise. Such trading strategies areknown as arbitrages and are often quite mathematically complex innature. This is particularly true for the financial derivatives marketswith which the present invention is mostly concerned.

Financial derivatives therefore have a well deserved reputation forcomplexity as far as arbitrage fair pricing and hence position riskmanagement theory is concerned. In practice however the theoreticalcomplexity is relatively easy to manage using affordable desktopsoftware applications which take the strain. This allows dealers whorely on such pricing models and so called trading tools to operate withthe same degree of confidence as others dealers do in less theoreticallydemanding markets.

In any case not all aspects of financial derivatives can be labelled ascomplex since for example their legal structure, the protocols oftransacting business and the product designs themselves are often easyto understand, relatively straight forward and indeed highlystandardised even where they are slightly intricate. The presentinvention is largely concerned with this simpler infrastructural side ofthe business.

Liquidity and the Purpose of Derivatives

Although they are hard to understand fully nonetheless the activities ofarbitrageurs play a very significant part in overall market activity.This is because their strategies ensure there is a close link betweenthe value of derivatives and the market price of their underlying cash.Trading a derivative thus becomes a viable alternative to using therelated cash market at least for exposure management purposes as opposedto inventory management purposes. Furthermore the capital efficiency ofderivatives resulting from leverage means that real money cashflowconcerns can be set aside from exposure requirements in these markets.This in turn means that base liquidity is less constrained and as aresult is often higher in derivative markets than in the underlyingcash.

In a competitive open market increased liquidity will typically appearas tighter average bid to offer price spreads. The lower bid/ask spreadrepresents a reduced cost of doing business to exposure managers as theyenter and exit their trading positions. Thus increased liquidity inderivatives markets make them attractive to traders on cost groundsalone regardless of what real money constraints (if any) they may have.

Consider for example a trader who wishes to temporarily exit a long cashposition (i.e. they have previously bought the underlying). The tradermay fear a drop in the market price of this cash asset but knows he willeventually need to re-establish the long position for inventorypurposes. Such a trader can chose to bear the full cash market exit andre-entry costs if they so wish. Alternatively they can go to the moreliquid associated derivatives market and take a new short position whoseprofit during the expected drop in the market price will fully offsetany losses on the cash because its value is so closely related to it.The trader may then when the time is right return to the derivativesmarket buying back the short and as a result will have churned hisposition more cheaply yet with the same results. Such activity is knownas hedging and a key raison detre of most derivatives markets.

As well as those hedgers who wish to lay off risk the derivativesmarkets also attract so called scalpers or market makers who seek tobenefit from the bid/ask spread in the knowledge that liquidity isusually so good they can exit quickly if the market moves against them.Liquidity thus breeds liquidity in a virtuous circle as risk istransferred around many market participants.

The History and Trading Microstructure of Futures Exchanges

The earliest derivatives were listed on commodity exchanges as so calledfutures contracts. These were used by farmers to secure their sellingprice far in advance of harvest (thus ensuring their annualprofitability) but were also used by the food production processing,manufacturing, marketing and retailing industries to secure their buyingprice for their future inventory needs. In addition to arbitrageurs theleverage available also attracted specialist scalpers and speculatorscalled local traders with no actual inventory to shift but whosepresence at the exchanges further added to liquidity.

To access the liquidity pool in such exchange traded futures productsrequired either for dealers to be exchange members themselves or forthem to be customers of members acting as so called futures brokers. Aswell as restricting who could execute business, exchanges also set thetrading rules and policed them to create high profile reputable markets.During the predefined trading hours for each market an orderlycentralised continuous and competitive public auction known as openoutcry was maintained under these trading rules. Open outcry as the nameimplies involves verbal bids and offers being made face to face in thetrading rings or pits. To facilitate customer order flow phone boothslined the arena around the pits. In open outcry verbal bids, offers andtrades were supplemented by hand signals in the pits themselves and thesame signals were used for communication between booth brokers and pitbrokers. Open outcry was made even more efficient by participantswearing jackets colour coded to their job role or brokerage firm. Pitdealers would also sport large badges etched with their individualtrader mnemonic (a three or four letter code) and exchange member ID. Inmost commodity types there was never more than one contract expiryavailable to trade per calendar month, thus each month could beallocated a unique single letter code.

In open outcry after a trade was agreed and checked each counterparty inthe pit would fill in an order ticket with their own half of the tradedetails i.e. bought or sold, price, number of lots, futures expiry monthcode and counterparty trader mnemonic. These so called filled orderswould be handed from the pit to so called runners who would process thepaperwork in order that matched trades could be efficiently registeredwith the exchange.

Much later in their history certain US based commodity exchanges beganlisting financial derivatives that were designed in analogy to commodityfutures. These products quickly became extremely successful andeffectively transformed their hosts into financial futures and optionsexchanges. To try and emulate these successes in foreign financialcentres around the world entirely new financial futures and optionsexchanges have been set up since the early 1980s. Some of these newerexchanges were however established using electronic order matchingrather than open outcry. It was argued at the time that the lack oflocals was detrimental to liquidity. Though it was not immediatelyobvious it has since become clear that independent scalpers can tradejust as effectively from offices in an electronic market however.History has since shown that it is the electronic financial futures andoptions exchanges that deliver the greater liquidity and so have acompetitive advantage over the more traditional open outcry model.

In recent years open outcry has been largely or completely supplanted byelectronic order matching even at the oldest exchanges. Despite thisprior to the present invention the superior power of computer basedmatching over human infrastructure to deliver new types of products hasremained unrecognised and unharnessed. Indeed modern electronicderivative exchanges without exception have limited themselves tolisting financial futures and options that could just as well be (and inmany cases historically once were) traded via open outcry.

The International Swaps and Derivatives Association (ISDA) Formation ofISDA

Bilaterally negotiated derivative contracts between banks and theirlarger customers or indeed other banks also began to appear in the early1980s. This was partly as a result of the futures exchanges' lack ofability to innovate in order to fully meet the exact needs of hedgersand speculators because they were at the time still constrained by theirtraditional human infrastructure.

Initially each bilateral deal took a lot of organisation to set up andcomplete with every bank having its own slightly different legaldocumentation. Yet by the mid 1980s genuine bid ask inter dealer marketshad emerged in some key financial products. These became commonlyreferred to as the Over The Counter or OTC markets to distinguish themfrom exchange traded financial futures and options. Paradoxicallyperhaps a significant part of the early growth of OTC derivatives can beattributed to the ability of banks to hedge their private financialderivative exposures on futures and options exchanges.

In 1985 as a result of the increased frequency of bilaterally negotiatedderivative trading a group of banks set up the International Swaps andDerivatives Association (ISDA) as a global trade organisation. Since itsinception ISDA has tried to streamline and efficiently reorganise themicrostructure of the OTC market by for example reducing dealer legaloverheads and by attempting to address their back office (i.e. tradeconfirmation and post trade management) overheads too.

Legal Structure

A schematic representation of the legal structure of a single ISDA basedderivatives trading relationship is shown in FIG. 1. Since OTCderivatives are leveraged any legal or other operational failings canresult in substantial losses. Therefore among ISDA's most notableaccomplishments was the development of its Master Agreement (see item106 of FIG. 1) and the publishing of a wide range of relateddocumentation materials and instruments covering a variety oftransaction types (see item 108 of FIG. 1). Note however the clumsy waythat each new trade has to be confirmed by appending a tradeconfirmation contract to the ISDA master agreement (see items 110, 112and 114 of FIG. 1). Note also that there must be at least one masteragreement between any pair of counterparties (see items 100 and 102 ofFIG. 1). ISDA therefore failed to address in a meaningful way thescalability of trade confirmation and new counterparty workload even asit addressed the legal robustness of each instance of the contractsconcerned.

To address the markets present failings on legal scalability ISDA haslong argued in favour of electronic straight through processing (STP).It is also fair to say that ISDA has pioneered efforts to identify andreduce all the sources of risk in the derivatives and risk managementbusinesses of its members. After ISDA's formation and the legalstreamlining of the OTC derivatives markets the interest rate swapsmarkets grew exponentially for a decade and came to dominate exchangetraded financial futures and options in terms of notional turnover.

Counterparty Credit Risk and Its Reduction

Although individual OTC counterparties would revalue their positions ona daily basis yet still all of the gains or losses associated with aposition were originally exchanged only at some future predefinedpayment dates. This introduced a very significant level of ‘counterpartycredit’ risk as market moves caused unrealised gains or losses to buildup ahead of the date of ultimate payment. Hence even before tradingpotential counterparties each had to consider if the other would becapable of paying what might become very substantial sums by thedeferred date. The high degree of potential credit risk requires prudentfirms to expend resources investigating each other's financialconditions in order that they set credit lines and limits for eachpotential counterparty.

Enormous investments in credit screening were thus required by the early1990s. Regulators and central banks were at this time often voicingconcerns over the impenetrable jungle of bilateral counterparty creditexposures within the financial system as a result of OTC derivativesgrowth. Given the growth in the importance of its markets, ISDAresponded by taking a lead in promoting the understanding and treatmentof derivatives and risk management from both public policy andregulatory capital perspectives. ISDA also further developed itsdocumentation and by the mid 1990s ISDA had introduced optional butlegally enforceable netting and collateral arrangements into itsdocumentation structure (see item 104 of FIG. 1). There has been asubstantial uptake of these optional arrangements ever since.

Operational Risk

The promotion of the risk-reducing effects of netting and collateral hasremained at the heart of ISDA's activities since they were firstintroduced. By contrast straight-through processing for bothinterest-rate derivatives and particularly credit derivatives remainseven today a vision rather than an achievement. Indeed new post tradeutilities, such as the DTCC Matching Service, Swapswire and SwapsClear,and other services are also trying to promote efficiency in the OTCderivatives market to some extent independently of ISDA.

In 2002 ISDA responded to these trends by focussing again on STP. It didthis by absorbing the hitherto independent trade organisationresponsible for the development of FpML (Financial products MarkupLanguage) into ISDA's organisational structure. Ultimately FpML which isnow used by all the new post trade utilities just mentioned should allowfor the total electronic integration and operational streamlining of theentire industry. As by design the FpML format is flexible enough toaccommodate all possible ISDA based derivative trade descriptions,direct communication across the full range of OTC trade services fromelectronic trading and confirmations to portfolio specification for riskanalysis (yet regardless of the specific software or hardwareinfrastructure supporting these transaction related activities) willfinally become possible.

One weakness of FpML in practice is that it is more flexible than isneeded for most transaction purposes. The flexibility to accommodate allpossible ISDA based derivative trade descriptions whilst useful inprinciple is of practical benefit only when all of a bank's systems havebeen upgraded to this standard. Indeed only when all other banks havealso fully installed FpML can the dream of a seamless operationalinfrastructure across the industry become a reality. It is of courseexpensive to implement FpML across even a single bank's entire range oftrading systems and such a spend is hard to justify when the existingsystems are already adequate for their tasks and there is no guaranteethat all other banks have made equally strong investments in FpML.

In December 2003 the ISDA strategy paper entitled ‘Going Forward: AStrategic Plan’ announced that a unified approach to directinginvestment by industry participants and service providers in developingnew services was needed. This paper was followed by another one in March2004 entitled ‘The Implementation Plan’ which highlighted specificconsiderations for implementing the goals set out in the Strategic Plan.The ISDA Operations Committee has thus created a blueprint for theoperational evolution of the OTC derivatives industry and launched anaggressive schedule for achieving improvements in processing.

The ISDA Operations Committee has conceded that over 80% of ISDA basedtransactions are highly standardised so the schedule for processingimprovements is starting with these most ‘plain vanilla’ products. Itremains to be seen if this latest ISDA initiative will yield benefits toall market participants as quickly as it hopes.

ISDA Today

Today ISDA is at its zenith covering all asset classes from‘traditional’ derivatives on interest rates, currencies, equities andeven commodities through to relatively new derivatives on energy andcredit. The OTC markets have grown very substantially from theirbeginnings in the 1980s mostly as a result of the increasingparticipation in and acceptance of ISDA based derivatives by all sectorsof the trading community. Another key factor has of course been the moregeneral availability of computer based derivative valuation tools butnonetheless it is fair to say the financial markets have beentransformed as a result of ISDA. Indeed more often than not today's cashmarkets are being driven by supply and demand changes in derivativesrather than the other way around.

The Modern Futures Exchange Explained Legal Structure

FIG. 2 shows a schematic representation of the legal structure ofexchange based derivatives trading. It is clearly more intricate thanFIG. 1 but crucially is far more scalable especially for smallerclients.

Brokerage agreements (see items 208 and 210 of FIG. 2) give customers(see items 202 and 204 of FIG. 2) access to exchange (see item 200 ofFIG. 2) via members (see items 220 and 222 of FIG. 2) acting as theirmain futures broker and executing trades on their behalf (see item 218of FIG. 2). Such ‘clearing’ members must therefore be members of boththe futures exchange and its clearing house (see item 230 of FIG. 2).This is achieved via exchange membership agreements (see items 214 and216 of FIG. 2) and clearing membership agreements (see items 224 and 226of FIG. 2) respectively. Members acting as brokers are required tocollect margins calls from customers and to enforce the rules of theclearing house as regards maintenance of sufficient margins in customeraccounts. Clients funds are protected because funds held in fulfilmentof margin rules and requirements must be kept separate from, orsegregated from, the member firms' own funds.

Not shown on the diagram are so called non clearing exchange membersbecause to access the market such members need a relationship with aclearing member in any case. They thus appear similar to clients. Shownseparately in FIG. 3 is the process permitted by exchange rules andsystems that allows a customer (see item 300 of FIG. 3) to use severaldifferent brokers. One broker may be used for execution of trades (seeitem 304 of FIG. 3) but another broker may be used for clearing (seeitem 306 of FIG. 3). The assigned filled orders are transferred from theresponsibility of the executing member to the clearing member within theclearing house (see item 310 of FIG. 3) via a process called a “give up”(see item 308 of FIG. 3), governed by a so called give up agreement (seeitem 302 of FIG. 3). Such give up instructions are usually handled bypost-trade exchange or clearing house software. The give up process forshort positions is not shown in FIG. 3 but is identical.

Other documents shown in FIG. 2 include the exchange's trading rules(see item 206 of FIG. 2) and master product specification (see item 212of FIG. 2). Such incorporation by reference is extremely efficientallowing for example the contract specifications of all existingpositions in a product to be efficiently updated if necessary from timeto time. A final contractual link that is worth mentioning is thatbetween an exchange and its clearing house (see item 228 of FIG. 2), foralthough this relationship is traditionally very stable exchanges suchas the Chicago Board of Trade have been known to switch from oneclearing house to another.

Overall the exchange's legal structure is extremely robust and thereforebeloved of regulators. In these circumstances and in stark contrast toISDA based derivatives, legal battles from disgruntled end users tryingto recover losses made on exchange traded derivatives are practicallyunheard of and never affect the exchange itself.

Trade and Risk Management Information

FIG. 4 shows a logical representation of operational information flow inexisting exchange based derivatives. Item 400 of FIG. 4 represents justone of the many dealers trading on the exchange. The dealers decisionswill be informed by general activity observable across various marketsand news as published by quote vendors (see item 402 of FIG. 4) such asReuters, Bloomberg etc. The dealer shown also has direct access to themarket place and via their own front office trading system (see item 404of FIG. 4) they are therefore likely to be a broker or a high volumetrader. Low volume traders will tend to place orders by telephone via abroker (not shown). The front office trading system typically connectsto the exchange via a so called exchange gateway (see item 408 of FIG.4) which forms the physical and logical boundary to the exchangemaintained systems.

There are typically two methods through which a trade can be occur onthe exchange a) a pre-matched bilaterally negotiated pair of trades canbe registered directly via so called wholesale trading facilities; or b)orders can be placed in the matching engine (see item 414 of FIG. 4) inthe hope that a counterparty can be found. In either case valid halftrades are entered into the trade registrations system (see item 418 ofFIG. 4) which forms part of the logical boundary between the exchangeand the clearing house systems. Whilst within the trade registrationsystem “give ups” can be executed by the appropriate back office (seeitem 416 of FIG. 4) before half trades are passed to the appropriateaccounts within the clearing house (see item 422 of FIG. 4).

To assist with generating a steady flow of matched trades the matchingtechnology also calculates market status information (see item 412 ofFIG. 4) such as the lowest unmatched sell orders known as the best askor offer and the highest unmatched buy orders known as the best bid.These are published via quote vendors (see item 402 of FIG. 4) and ofcourse to the trading screens themselves (see item 404 of FIG. 4). Thevolumes of unfilled bids and asks at each permissible price respectivelybelow and above the best bid and ask are known as the orderbook and areoften also publish. The market supervision function (see item 410 ofFIG. 4) is one of the most important in the exchange. This is usuallyperformed by skilled individuals in the exchange's market control centrewho continually monitor the market status and whose principle roles area) to enforce exchange rules; b) maintain an orderly market and c) setthe daily settlement prices (see item 420 of FIG. 4). For example marketsupervisors will be able to reject attempts to register wholesale tradesthat do not conform to the appropriate exchange rules.

Daily settlement prices (see item 420 of FIG. 4) are used by theclearing house (see item 422 of FIG. 4) to calculate variation margincalls to or from members (see item 416 of FIG. 4) and because of theirimportance are also published by quote vendors (see item 402 of FIG. 4).Another important set of published information is related to totaloutstanding contracts on which initial margin is collected and is knownas open interest (see item 424 of FIG. 4).

Perhaps most importantly straight through processing (STP) is completelystandard and in fact mandatory in the modern electronic futures exchangemodel. The back office trading reports (see item 406 of FIG. 4) arethese days likely to be in electronic format and both these and thefront office trading systems can therefore be linked into front officeposition keeping, risk management and reconciliation systems if deemednecessary (not shown). Much of the infrastructure for STP is nonethelessprovided by the exchange and its clearing house for relatively modestand totally transparent fees per lot charges. The modern electronicfutures exchange model therefore not only provides good cost effectiveSTP infrastructure but upgrades are automatically enforced across theuser base as they are centrally managed by the exchange and its clearinghouse.

In addition a free risk management service is provided via dailysettlements greatly reducing internal risk management costs of smalleror less sophisticated financial institutions. Exchanges also publishcertain trading information and so their markets are generally far moretransparent than their OTC equivalents

The supervisory environment of a genuine exchange is such that acustomer is protected by the exchange's trading rules and members areappropriately punished for breaches of best practice conduct. Thisprotection is not available in the OTC derivatives markets.

Margining and Anonymity

Margining is the deposit of cash or collateral placed with the clearinghouse when you create a futures or options position. Unlike ISDA'scollateral management and other independent initiatives within the OTCbased market the use of clearing and central counterparty servicesprovided by the clearing house is mandatory at a futures exchange. In aprocess known as novation the web of bilateral counterparty creditexposures is first replaced by all members' contracts becoming with theclearing house. In a process known as margining collateral is thendeposited at the clearing house and topped up on an as needed basis toguarantee performance of the contract and thus eliminate counterpartycredit risk.

The exchange's margining system provides important protection to themarket. This protection is arranged by the clearing house whichguarantees performance of contracts registered with it by its members.Any exchange member who is not a member of the clearing house musttherefore have a clearing agreement with a clearing member in order totransact business on the exchange. To become a clearing member certainminimum financial requirements laid down by the exchange and clearinghouse must be met. Members are monitored to ensure that they continue tomeet specified criteria. There are usually different categories ofclearing membership depending on whether the member clears only its ownbusiness or can act as a broker etc.

After novation the clearing house ensures the financial performance oftrades through to final cash settlement or delivery. To assess andcontrol the risk associated with its position as central counterparty,the clearing house calculates and collects of initial and variationmargin payments. These are explained below.

Novation and margining together put all exchange trades in a singleproduct on the same footing regardless of originating counterparties andderivative contracts therefore behave just like negotiable securitieswhen viewed from within the exchange's membership and clearingstructure. The combination of the clearing house with electronic tradingmeans that anonymous trading is standard practice when dealing on amodern futures exchange and this is especially attractive to largercustomers. The anonymous trading advantage cannot be replicated in thetraditional bilaterally negotiated market. Margining services were oncea unique distinction between exchange traded futures and options and theway the OTC derivatives market worked. However new post trade centralcounterparty utilities, such as the DTCC Matching Service andSwapsClear, have emerged in recent years and blurred this distinction.

Variation Margin and Daily Settlement Prices

At a fixed time of the trading day, usually after the close of tradingof in a contract series, the exchange determines and then publishes socalled daily settlement prices for each expiry (and where applicablestrike) within the series. Daily settlement prices are simply a set ofreference prices consistent with market activity at settlement time. Thekey to the variation margin process is the exchange's determination ofan accurate daily settlement price for each and every futures andoptions contract. If at settlement time there is insufficient tradingactivity to observe a settlement price directly, market supervision canuse prices generated by a relevant pricing model based on prices from arelated market. Settlement prices are automatically transmitted tomember back offices.

Based on the daily settlement prices the open positions all participantsare market to market and money to cover losses is collected by clearingmember firms and presented to the clearing house. Such accounting andcollection is followed by a disbursement of day to day gains to clearingmember firms. This process ensures that all members' customers receivethe gains (and pay the losses) associated with their positions each day.This process is known as variation margining and means that allhistorical profits and losses are immediately realised. Hence thestresses caused by past negative performance on losing positions are notallowed to build unchecked to levels that may threaten the goodperformance of profitable positions going forward. The protectionafforded by variation margin is augmented by the collection of initialmargin which effectively eliminates the residual counterparty creditexposure between the clearing house and any of its members.

Fungible Contracts and Regular Trading Hours

It is worth noting the fact that different exchanges can use the sameclearing house which allows positions to be initiated on one exchangeand closed on another.

The most straight forward example of fungible contracts in practice isthe way in which the Options Clearing Corp (OCC) has since 1975 beenused as the central clearing corporation for all US exchange-listedequity options. The Chicago Board Options Exchange (CBOE), The AmericanStock Exchange (AMEX), The Philadelphia Stock Exchange (PHLX), ThePacific Exchange (PCX) New York Stock Exchange (NYSE), The NationalAssociation of Securities Dealers (NASD). The International SecuritiesExchange (ISE) and The Boston Stock Exchange are all OCC participantexchanges. Where contracts are dual listed a position initiated on oneexchange can be closed on another.

A more interesting example of fungible contracts is the system of MutualOffset (MOS) pioneered in 1984 by the Chicago Mercantile Exchange (CME)and the then Singapore International Monetary Exchange (SIMEX). Thiselectronic linkage effectively allows give-ups between the two exchangesso for example a Eurodollar future executed in Singapore can be clearedin Chicago and hence closed out against an open position alreadyestablished there. The two exchanges remained separate with distinctclearing houses and because of their different closing times distinctdaily settlement prices. As a result of the mismatch of regular tradinghours between the two exchanges daily variation margin call imbalancesmust be absorbed by the two clearing houses.

Initial Margin

The collection of initial margin provides protection to members and theclearing house in the event that sufficient client funds are not readilyavailable to satisfy day to day variation margin requirements. Bothlongs and shorts must have paid initial margin in order to hold open aposition. In effect initial margin is the prepayment of worst casevariation margin calls associated with all members' customers positions.

Initial margin thus guarantees in advance that all those due to receivegains will continue to get them even on a day when someone defaults. Inthis way the initial margin acts as a deposit which may be used by themembers and the clearing house to satisfy the customer's or clearingmember's obligations if the customer or clearing member fails to do so.

The amount of this initial margin is set by the clearing house based onhistorical trends in terms of market price volatility as well asforthcoming events which may further affect volatility. An account'sinitial margin requirement is calculated as the largest possible loss(including all futures and options positions) that a trading accountwould face in the worst case scenario of market events. The details ofthese calculations vary from clearing house to clearing house but oftenrecognise that customers' portfolios may hold offsetting positions.However clearing houses must remain conservative as excessively lowlevels of initial margin risk the integrity of the exchange. If on theother hand offsetting positions are not recognised appropriately,traders may not be able to make the most efficient use of theirresources, which may lead to their exiting the market in favour of OTCor another exchange venue. Good quality margining is thus essential tomaintaining liquidity.

Cheap Custody and Valuation Services

Typically exchanges and their clearing houses charge a per lot fee attime of trade as do their members when acting as brokers. However thereare services that are provided effectively for free. For example thefutures clearing house is not only a central counterparty but acts ipsofacto as a central depository with members acting as custodians fortheir clients. No direct fees are charged for holding positions however.Also the calculation of variation margin calls represents a freevaluation service and the calculation of initial margin represents afree value at risk calculation (albeit often an overly conservativeone).

Competition Between ISDA and Financial Exchanges Increasing ISDADominance?

The story of exchange based financial derivatives trading is that ofenormous growth but also of decline relative to OTC derivatives. It istrue that exchange traded interest rate products have apparently shownstrong growth in absolute terms, but their relative decline isremarkable. The OTC Interest Rate Swaps market has ballooned into by farthe biggest derivatives markets in the world. Thus, apart from a one-offboost to liquidity when rate futures became electronic, the picture ofincreasing marginalisation is clear. As ISDA continues its crusade tostreamline the OTC market microstructure by setting STP standards thevalue add of electronic futures exchanges will be further eroded.

Already some exchange traded equity options are increasingly underthreat from competing OTC ‘look alike’ business which is also quoted inexactly the same way as the exchange options. However this is largely anartefact of investment bank equity options dealers not being properlycharged for the full cost of their OTC back office whilst being fullycharged for exchange brokerage. Nonetheless certain futures and optionsexchanges appear unable to promote the true benefits of exchangederivatives over bilateral negotiation of contracts in this particularproduct group.

If as a result of operational streamlining electronic trading ofInterest Rate Swaps takes hold in the ISDA based markets an absolutedecline in exchange traded interest rate products could also result. Theconservative market microstructure retained by exchanges since theiropen outcry days would be strongly implicated in this sorry state ofaffairs if that happened.

Liquidity and the Exchanges

Despite the apparent negative picture from historical trends a properanalysis of these shows that ISDA based OTC markets are actuallyevolving towards the electronic futures and options exchange centralmarkets model or at least as closely as they can to it. Thus OTC marketsnow have (a) centrally designed contract specifications via the ISDAdefinitions; and (b) some central clearing via SwapsClear, the DTCC etc;and even (c) a centrally designed API's via the FpML and FIX protocols.Clearly the derivatives exchange model has some true merit. By contrastISDA based negotiation of contracts clearly has scalability problemsfrom both the mountain of confirmations and the bilateral masteragreements required. These scalability problems have recently come verysharply into focus with the advent of credit derivatives but are alsopresent in more established ISDA based products.

Whilst the back office operational difficulties with confirmations canbe addressed via STP the bilateral master agreements required pose amore fundamental scalability problem. The setting up of ISDA masteragreements and the monitoring of bilateral counterparty credit risk areboth costly non trivial tasks. There are therefore many smaller tradersexcluded from the ISDA based market.

The contrast with exchange traded financial futures could not be morestark where even in the electronic age office based independent traders(the modern ‘locals’) can constitute up to 40% of the daily turnover.

One can therefore remain quite optimistic for futures exchanges as agroup. They remain structurally better positioned to deliver superiorscalability of participation and in the electronic age have vastlyincreased their reach and distribution. With broad participation anddistribution can come superior liquidity and liquidity is key in anycompetition between derivatives markets.

Unfortunately many for futures exchanges have used the opportunity ofelectronic trading simply to compete with exchanges in other financialcentres. However most exchanges have also worked hard to offeralternative access to their infrastructure via so called wholesaletrading facilities that allow dealers to agree transactions over thephone OTC-style and then register these as futures or options on theexchange.

The true benefits of exchange derivatives over bilateral negotiation ofcontracts are best observed in the growth of electronic foreign exchangefutures, most notably at the CME. It is no mere coincidence that foreignexchange futures already meet the needs of forex hedgers and speculatorsproperly as evidenced a) by the fact that OTC foreign exchange forwardsare quoted in exactly the same way as them; and b) the universe ofcurrency pairs is small enough to be fully represented on exchange(contrast equities at most exchanges).

The Exact Context of the Present Invention

The exact context of the present invention can only be properlyunderstood in the context of the legal and operation structure of themodern electronic futures exchange and its ISDA rival, as alreadydescribed. The well known historical inability of futures exchanges todeliver product innovation has also already been alluded to. Yet it is avery poorly understood fact that many operational, legal andorganisational advantages existing in a futures exchange model cannoteasily be recreated even in the best practice bilateral OTC model. Thetrue context of the present invention is simply the observation that theconverse is not true i.e. exchanges can be adapted to recreate theadvantages of OTC products even though this has never been done before.

The invention aims to reengineer the existing electronic futuresexchange model in order to establish convenient on exchange access tospot and forward derivatives normally only available on the ISDA basedOTC market. Thus electronic futures and options exchanges can becometruly worthy of the title ‘derivatives exchanges’ by fully meeting theexact needs of hedgers and speculators for the first time as ISDA hasnow been doing for the past twenty years.

The ability of office based independent traders to participate in theinvention's new ISDA-like derivatives products plus the release ofexisting OTC participants from ISDA's scalability problems (particularlyin credit derivatives) can be expected to lead to an explosion inliquidity. In short the invention aims to deliver a far better way oftrading. Also the problems of exchange traded equity options will cometo be seen as a temporary aberration and an artefact of a mispricing ofinfrastructural services.

Given the stated aim of the present invention it can only be properlyunderstood together with some basic details of the major ISDA basedderivatives markets as compared to existing exchange traded financialfutures and options products. We therefore now turn to these matters.

Major Exchange Traded and ISDA Based Debt Derivative Products InterestRate Financial Futures and Options

There are two established types plus one less established type:

-   Short Term Interest Rate (STIR) futures such as CME three month    Eurodollar, LIFFE three month EURIBOR etc; and-   Bond futures such as the CBoT ten year T-note and the EUREX Bund-   The relatively new swap related futures like the LIFFE Swapnote.

There are other less typical types like the SyFE products.

Short Term Interest Rate (STIR) Futures

Mainstream STIR futures are cash settled futures (see FIG. 5) and wetherefore will take this opportunity to explain how this process worksin general. In step 500 of FIG. 5 the exchange determines whether thelast trading day has arrived. If the last trading day has not arrivedthen normally daily settlement occurs and the position remains as afutures or options one as indicated at endpoint 502 of FIG. 5. Howeverif the last trading day has arrived then the final daily settlementprice known as the Expiry Day Settlement Price (EDSP) is set at step 504of FIG. 5 via a predefined formula (see 506 of FIG. 5) linked toexternal data related to the underlying market. As a result of this atthe endpoint 508 of FIG. 5 the final variation margin is called, theposition is deleted from the clearing house register and initial marginis returned.

For mainstream STIR futures the external underlying market data for cashsettlement is an appropriate fixing taken from the deposit market. Forexample CME Eurodollar futures EDSP at 11 am London time to a pricerelated to the London Inter-Bank Offer Rate (LIBOR) for three monthdollar deposits trading at that time as calculated by the BritishBankers Association and published as a benchmark fixing. Specificallythe formula linked to this external underlying (see 506 of FIG. 5) issimply:CME Eurodollar EDSP=100 minus BBA 3-month $ LIBOR

Deliverable Bond Futures

Mainstream bond (or note) futures are physically delivered, see FIG. 6.In step 600 of FIG. 6 the exchange determines whether the last tradingday has arrived. If the last trading day has not arrived and there is nooption to make early delivery as indicated at step 602 of FIG. 6, orindeed the option exists but is not exercised then position remains as abond future (see 604 of FIG. 6).

The specified criteria for the bonds deliverable into a futures contractlisted on an exchange can be found in its contract specifications. Theexchange will publish an initial list of the bonds, as shown at step 612of FIG. 6, which it believes form the complete list of deliverables intime for market feedback. Such a list is commonly known as the basket.The basket contains different bonds which vary in their characteristicsbut match a set of criteria specified by the exchange for each differenttype of bond future.

Most often the bonds in a particular futures basket will only differ intheir coupons and times to maturity. The bonds deliverable will be ofthe credit quality defined in the contract specifications of theparticular bond future under consideration. This usually means arestriction to a single named issuer for each bond futures contract. Inprinciple the issuer could be anything from a small entity up to the USgovernment but a contract will only maintain its integrity if the supplyof the underlying is sufficiently great i.e. it becomes hard to engineera “short squeeze”. For this reason and because of their benchmark statusin the cash bond markets, government bond futures predominate in theirdomestic futures exchanges around the world.

Having published the initial list of deliverables and taken into accountmarket feedback (see 610 of FIG. 6), any errors made can be corrected ornew issues included in the deliverable list. Eventually the exchangewill close the basket at the time it publishes the final list ofdeliverables (see 608 of FIG. 6). This final list is definitive and anyremaining mismatches with the official selection criteria for pickingdeliverables as laid out in the contract specifications become moot.

The process of delivery established by the exchange gives tradersholding a short futures position the choice to deliver any bond from thelist of deliverables. Each bond is assigned a conversion factor which isapplied to the final invoice price calculation should it be deliveredand is also published in the lists of deliverables together with accruedinterest information (see 608 and 612 of FIG. 6). This conversion factoris the mechanism which brings the maturity and coupon differences of thedeliverable bonds onto a common base and is intended to make all of thebonds almost equally attractive for delivery. In practice howeverdifference remain and a particular bond known as the cheapest to deliveris the most attractive.

If the last trading day has arrived or an early delivery option has beenexercised then the short futures holder must notify the clearing housewhich deliverable from the list they have elected to deliver (see 606 ofFIG. 6). The clearing house can then assign a long futures holder (see614 of FIG. 6) either at random or according to some other rule to takedelivery.

During the deliverable period of the futures contract, which may be amonth or just a single day, the daily settlement price is known as theExchange Delivery Settlement Price (EDSP) but is set by the marketsupervisor according to prevailing conditions in the futures market asnormal (see 616 of FIG. 6). For each lot short the bond seller deliversthe same face value of bond as the notional size of the futures contract(e.g. $100,000 for CBoT ten year T-note future) in return for theproceeds of the sale as calculated by the clearing house (see 618 ofFIG. 6). The proceeds of the sale resulting from a single delivery aredetermined by the EDSP multiplied by the delivered bond's conversionfactor and adjusted for accumulated accrued interest at delivery. Thisis called the invoice amount:Invoice amount=Nominal Size*(EDSP %*Conversion factor+accrued interest%)

Finally as shown at the endpoint 620 of FIG. 6, the long futures holderpays this invoicing amount to short futures holder in exchange forelected bonds, relevant futures positions are closed and initial marginis returned. This transaction in the cash bond market prompted by thechoice of bond to deliver by the short futures holder is called makingdelivery.

It is worth noting that when a bond futures contract is bought or sold,it is not always with the intention of holding the contract until expiryand then making or taking delivery of an underlying bond. A considerableproportion of the market use bond futures only for exposure management.Accordingly as a deliverable futures contract nears expiry, the openinterest (number of open positions) in the contract begins to decline aspositions are transferred into the next available contract. This isknown as the ‘roll’.

Swap Related Futures

These products are relatively new and are cash settled (see FIG. 5).

Swap related futures give cash settled exposure akin to what would beachieved by a bond future whose underlying CTD carried the creditquality of the OTC Interest Rate Swap market and also had a perfectmaturity match i.e. CBoT ten year Swap future is linked to an exact 10year term of the swap market.

There are actually two competing designs but both behave essentiallysimilarly:

-   1. The CBoT Swap future design; and-   2. “Swapnote”—Arguably the most sophisticated futures contract in    the world.

Swapnote is traded under license (see the patent U.S. Pat. No. 6,304,858B1, Oct. 16, 2001 ) on the LIFFE and TIFFE markets and exactly emulatesthe exposure already described.

By contrast the M-year CBoT Swap future design has a much simpler expiryday settlement formula (see 506 of FIG. 5):${{CBoT}\quad{Swap}\quad{Future}\quad{EDSP}} = {\frac{C}{S} + {\left( {1 - \frac{C}{S}} \right)*\left( {1 + \frac{S\quad\%}{2}} \right)^{\frac{1}{2*m}}}}$where,

-   -   S represents the ISDA Benchmark Rate for the M-year U.S. dollar        interest rate swap on the last day of trading, expressed in        percent terms; and    -   C represents the notional coupon for the future, expressed in        percent terms (currently C=6 for both the 5-year and 10-year        Swap futures that are listed)

The advantage of both Swapnote and CBoT Swap futures over deliverablebond futures is the fact that being cash settled there is no possibilityof a short squeeze of the cheapest to deliver cash bond . . . Howeverthere can be problems with cash settlement too—These swap futures aredesigned to give access to swap exposures for participants who cannotnormally trade ISDA IRSs (see below). Such participants will normallywant continuing exposure after futures expiry and the only way toachieve this for them is to rollover rather than go to cash settlement.Because of this captive market ‘the roll’ has a tendency to be pricedaway from fair value as market makers cash in on their relativeadvantage, caused by the fact they can trade OTC whilst their captivecounterparties cannot.

Cash Settled Options

Often options are cash settled as in FIG. 5 with the EDSP for callsbeing the premium quotation equal to the maximum of zero or the value ofa purchase at strike followed by a sale at the underlying referencefixing. Thus if the options tick size is the same as the futures as isoften the case the formula (see 506 of FIG. 5) is:Call EDSP=Max(0,Reference Price−Strike Price)

Likewise the EDSP formula (see 506 of FIG. 5) for a put is:Put EDSP=Max(0, Strike Price−Reference Price)

Deliverable Options

The alternative to cash settlement for options is physical delivery intofutures (see FIG. 7) which is for example used in so called serial andmid-curve options in the CME Eurodollar and also in most options on bondfutures. In step 702 of FIG. 7 the exchange determines whether theoption is in the money at expiry using a reference price (see 700 ofFIG. 7). This check is simply the same as checking if the option EDSPwould be greater than zero were it a cash settled one. If not the optionreaches endpoint 704 of FIG. 7, remains as an option and expiresworthless. Alternatively for American exercise style options, the optionholder has the additional right to manually exercise at any time priorto expiry (see 706 of FIG. 7) but if the option is not exercised in thisway either we are again at endpoint 704 of FIG. 7.

Exercise of options either automatically or manually has differentdelivery implications depending on whether the option held is a put or acall (see 708 of FIG. 7). Call option holders receive upon exercise along futures position at the option's strike price from the call optionssellers, who therefore has a short futures position, and at the sametime the call options positions are deleted from the clearing houseregister and initial margin returned (see 710 of FIG. 7). Likewise putoption holders receive upon exercise a short futures position at theoption's strike price from the put options sellers, who therefore has along futures position, and at the same time the put options positionsare deleted from the clearing house register and initial margin returned(see 712 of FIG. 7).

Financial Futures Quotation and Design Standards

In traditional futures exchanges products are highly standardised.Generally speaking the contract quotation for front office tradingpurposes and its valuation for back office purposes are identical up toa constant factor i.e. what you see is what you get.

Thus short term interest rate futures such as CME Eurodollar futures andoptions products have a constant tick value i.e. a move in price of asingle lot of 0.005 is always worth $12.50 regardless. No proper accountis taken of:

-   -   a) Convexity so overall forward interest rate levels are ignored        (in fact given the design of the CME Eurodollar futures in the        unlikely event of three month rates going above 100% the futures        would be trading at negative price); and also    -   b) Time value of money is ignored so tick value is the same        regardless of how far away an expiry is and what the relevant        spot interest rate levels would be to properly value a        corresponding forward; and also    -   c) The actual days in the deposit market fixing that underlies        each contract expiry is ignored i.e. day count is simplified to        three months equals ¼ of a year.

Even in the exceptional case of the Sydney Futures Exchange (SyFE) whereconvexity has been included the relationship between quotation andvaluation remains relatively simple, inflexible and standardised. Anyvariable parameters however relevant are ignored and specificallyfactors b) and c) are not taken into account.

Such conventional constraints on financial futures price quotations andvaluations can largely be put down the exchanges' history as open outcrymarkets where what you see is what you get was the most appropriatemodel. Also before the advent of computers more sophisticated quotationswould have been difficult to implement manually. The limitation to oneexpiry per calendar month per product is also a relic from those bygonedays. In the age of computer based trading such constraints can be setaside.

A final constraint that is certainly counterproductive and again merelyconventional is the fact that all term futures products are listed as socalled forward-forward products. Thus for example every point on theprice curve defined by the CME Eurodollar future represents a threemonth term exposure. If forward-forward curves are filled in to includeall possible expiry dates you will have a single contract going to finalcompletion each day. By contrast spot market curves will containdifferent maturity terms but all for ‘immediate’ delivery whilst trueforward market curves will also contain different maturity terms but allfor deferred delivery on the same forward date.

OTC Interest Rate Derivatives

There are three mainstream interbank OTC interest market types:

-   The money market derivatives known as Overnight Indexed Swaps (OISs)    and their associated options; plus-   The money market derivatives known as Forward Rate Agreements    (FRAs).-   The long term derivatives known as Interest Rate Swaps (IRSs).

There are a large number of other less actively quoted products orvariants on the above e.g. asset swaps which are simply a variant ofstandard IRSs linked to the cash flows of a particular bond.

According to ISDA the total notional outstanding in OTC interest ratederivatives grew almost 16 percent in the first half of 2004 to $164.49trillion, mirroring growth in the second half of 2003.

Overnight Indexed Swap (OIS)

In an OIS one side pays a money market term deposit interest at a levelnegotiated at time of trading and the other side the relevant overnightindex (e.g. the Fed funds rate) compounded over the same term. An OISthus replicates off-balance sheet a mismatched deposit position of 1) ashort term loan funded by an overnight deposit; or 2) an overnight loanfunded by a short term deposit, depending on whether you are receivingor paying the term rate. Both rates are calculated on an agreed notionalprincipal which does not however change hands.

Forward Rate Agreement (FRA)

In a FRA one side pays a term deposit interest at a level negotiated attime of trading and the other side a market rate for the deposit atcontract maturity. On the day the FRA is priced the market rate isdefined by the relevant interest rate fixing (e.g. the BBA 1-month $LIBOR rate). Crucially both payments are discounted using this sameinterest rate fixing. Because of this a FRA, as the name implies, trulyallows traders to lock in a forward rate as they can simply use thedeposit market to complete their hedge. Both rates are calculated on anagreed notional principal which does not however change hands. Threemonth and six month FRAs are the most common.

Interest Rate Swap (IRS)

In an IRS one side regularly (e.g. every three months) pays a fixedinterest rate while the other side makes regular payments based on afloating interest rate (e.g. the BBA 3-month $ LIBOR rate). The fixedinterest rate is struck at a level negotiated at time of trading anddepends on the term of the contract. Both rates are calculated on anagreed notional principal which does not however change hands at finalmaturity. An interest rate swap is thus very similar to a sequence orstrip of FRAs all struck at the same fixed rate.

The purpose of an IRS is these days usually to manage fixed income (i.e.bond) portfolios effectively. However the earliest transactions of thistype where used by issuers to take advantage of imbalances between theirstanding amongst investors in the capital and money markets respectivelyi.e. to achieve minimum cost of funds.

The Money Market Convention and Beyond

As might be expected both FRAs, OISs and certain forex derivatives knownas swap points are quoted based on the money market convention as usedin the cash depo and repo markets. This has a number of advantages forusers:

-   No need to remember complicated expiry date formulas (contrast with    CME Eurodollars which expire two business days prior to third    Wednesday of delivery month!)-   Liquidity is concentrated at the same on-the-run points across    different product types thereby maximising the ability to arbitrage.    For example forward swap points versus depo market versus spot FX    and outright FX forwards form a so called box trade arbitrage.

IRSs are also quoted in this manner but at longer term maturities. Thusthe IRS market will only quote active two way markets at maturities of awhole number of years i.e. spot plus 1 year, spot plus 2 years etc. outto 30 or even 50 years in the futures.

OTC Credit Derivatives

In the traditional debt markets poorer credit (higher risk) borrowersmust pay higher rates than lower risk borrowers. Conversely investorsmay generally assess the risk of a particular borrower in terms of thehigher or lower market rates prevailing for their debt. Howeverprevailing rates have to be seen in the context of the general supplyand demand conditions that affect all debt. In particular the generallevel of riskless government or IRS yields will underlay movements inmarket rates for all other borrowers' debt. For this reason liquidityhas tended to concentrate in these two markets at the expense ofcorporate debt.

Credit derivatives have become increasingly popular since the mid-1990sand according to ISDA notional outstanding grew 44 percent in the firsthalf of 2004 to $5.44 trillion, compared with 33 percent growth reportedduring the second half of 2003. These are impressive growth rates butthe market is still small compared to OTC interest rate derivatives.

As a result of these growth rates the theory and quantitativemeasurement of credit has had a tremendous boost in recent years and itis now apparent to bank strategists that credit derivatives have onlyjust begun to create truly liquid markets in pure credit exposure. Asunderstanding of these products has grown the market has come to realisethat pure credit exposure represents a separate asset class from bothequity and interest rate products and due the large amount ofoutstanding underlying debt the potential of this sector is vast inprinciple.

The main credit derivative market types are:

-   Single name Credit Default Swaps (CDSs)-   Index CDSs, tranched indices and correlation-   Synthetic CDOs    Although there are several other we will not discuss here.

Single Name Credit Default Swap (CDS)

Most of these products are first created at the 5 year maturity point.In a single name CDS one side (protection seller) regularly pays a fixedrate called the “spread” (e.g. every three months) while the other side(the protection seller) makes payments only in the event of a creditdefault. As the name implies the spread premium of a single name CDS isclosely associated with the credit spread over benchmark for the sameborrower's actual debt. In return for receiving the spread premium theprotection seller contracts to pay the buyer the full face value plusaccrued interest for whichever qualifying debt (i.e. the loans, bonds,convertibles etc from the defaulting issuer) the protection buyerchooses to deliver after a credit event i.e. in the event of a defaultby the issuer.

Index CDSs, Tranched Indices and Correlation

A CDS Index is just a set of single name CDSs traded as a group. Howeverthe importance of this class of derivatives arises from their beingdesigned to promote liquidity. Indeed credit derivative index productsare comprised of the most liquid names in the single name market at thetime they are first issued. Another liquidity promoting feature is thatevery six months the existing benchmark CDS index is rolled into a newfive year CDS index “on the run” benchmark at which time also newlyactive names can enter the index. Indices of this type have thereforebecome liquid benchmarks and have thus become essential tools formanaging risk in other credit derivatives.

The index tranche market is also very interesting. The concept is thesame as for cash CDOs i.e. tranches are defined by two percentage facevalue numbers with the attachment point defining the minimum losses towhich the protection seller is exposed and the detachment point definingthe maximum losses.

As the attachment and detachment points are standard (i.e. 0%-3%, 3%-6%,6%-9% etc in Europe, 0%-3%, 3%-7%, 7%-10% etc in North America) a liquidmarket for correlation has developed.

The fair spread premium for an index depends on the overall risk whichis a function of the individual names in the underlying portfolio andhow diversified the it is. In other words the default correlation mustbe known in order to fair value an index CDS. Interestingly indextranches have different exposures to correlation. For example highercorrelations makes the risk within different tranches more equal whichbenefits investors in the most junior tranche whilst hurting investorsin the higher seniority tranches.

The Credit Market Convention

Since Q2 2003 market makers decided to concentrate CDS liquidity byquoting only four value dates in the year namely 20th March, 20th June,20th September and 20th December or the next available business day ifthe standard date falls on a weekend or holiday. Despite this you can inprinciple trade any dates according to ISDA documentation.

Synthetic CDOs

The development of synthetic CDOs is a logical extension ofsecuritisation and credit derivatives. A synthetic CDO is then simply atranched portfolio-linked credit derivative (i.e. non standard CDSindex) packaged inside an SPV and rather confusingly isn't directlycollateralised with actual debt. The first synthetic CDOs were reportedas typically being used in order to exploit regulatory and taxarbitrages of one kind or another. However by 2000 the profile of dealschanged from balance sheet driven to value driven. In a synthetic CDO,no legal or economic transfer of bonds or loans take place, with theunderlying reference pool of assets remaining on the balance sheet ofthe originator. The impact on the single name CDS market has been tobuild up liquidity in those names that were common reference names insynthetic CDOs.

SUMMARY OF THE INVENTION

The invention is based on the modification of the components that makeup a modern electronic futures exchange in order to vastly extend therange of products and services supported. Although some of the newproducts described are designed to mimic existing products the modifiedelectronic futures exchange has significant structural advantages in anycase over rival methods of delivering similar exposures.

Accordingly, it is an object of the present invention to provide a noveland highly efficient method for accessing and managing exact OTC ISDAtype credit default swap like exposures within a fully integrated broadbased organized credit derivatives market that also includes novelrecovery based product and novel options.

It is an additional object of the present invention to provide a noveland highly efficient method for accessing and managing exact OTC ISDAtype interest rate swap and FRA like exposures

It is an another object of the present invention to provide a novelhybrid bond like futures that deliver exact OTC ISDA type interest rateand credit exposure upon expiry.

It is a further object of the present invention to provide a novel andhighly efficient method for accessing and managing exact OTC ISDA typeovernight index swap exposures

It is yet another object of the present invention to provide an upgradedclearing cycle capable of dealing with these new products and existingexchange traded products in a truly global market place.

Additionally, it is another object of the present invention to provide anovel and highly efficient interbank deposit market that removes theneed for counterparty credit calculations.

Furthermore it is another object of the present invention to provide anew kind of securities market based for a broad range of productsincluding those normally only issued by so called special purposevehicles.

Ultimately it is the aim of this invention to provide a fullyintegrated, operationally efficient, broad based and organized marketfor the full spectrum of financial instruments.

BRIEF DESCRIPTION OF THE DIAGRAMS

A more complete appreciation of the invention and many of the attendantadvantages thereof will be readily obtained as the same becomes betterunderstood by reference to the following detailed description whenconsidered in connection with the accompanying drawings, wherein:

FIG. 1 is a schematic representation of the legal structure of ISDAbased derivatives trading;

FIG. 2 is a schematic representation of the legal structure of exchangebased derivatives trading;

FIG. 3 is a schematic representation of the give up/in process ofexchange based derivatives trading;

FIG. 4 is a logical representation of information flow in existingexchange based derivatives;

FIG. 5 is a flow diagram representing existing cash settled exchangetraded futures and options;

FIG. 6 is a flow diagram representing the physical delivery process forexchange traded futures as used for existing bond futures;

FIG. 7 is a flow diagram representing existing physical delivery intofutures of exchange traded American options;

FIG. 8 shows the transformation of information flow in the inventionbased derivatives exchange;

FIG. 9 shows how a front office screen for an exchange traded creditderivative might appear on 3 Oct. 2005;

FIG. 10 shows the Adapted For Exchange New Credit Derivative inventionmapping of Traded Spread Product orders onto Internal Matching Productorders;

FIG. 11 shows the Adapted For Exchange New Credit Derivative inventionmapping of Internal Matching Product orderbook for display as TradedSpread Product;

FIG. 12 shows the Adapted For Exchange New Credit Derivative inventionmapping of Internal Matching Product fills into front office TradedSpread Product fills;

FIG. 13 shows the Adapted For Exchange New Credit Derivative inventionflow diagram for pro rata Credit Coupon Product pricing breakdown;

FIG. 14 shows the Adapted For Exchange New Credit Derivative inventionflow diagram for Credit Coupon Product pricing breakdown from marketprices;

FIG. 15 shows the Adapted For Exchange New Credit Derivative inventionflow diagram for Credit Coupon Product daily settlement calculation;

FIG. 16 shows a schematic overview of the event protection products andprocesses which generate credit protection within the Adapted ForExchange New Credit Derivative invention, including the calling of anotional credit event and its consequences;

FIG. 17 shows the Adapted For Exchange New Interest Rate Swap inventionflow diagram for Floating and Fixed Coupon Product position breakdown;

FIG. 18 shows the Adapted For Exchange New Interest Rate Swap inventionflow diagram for Floating and Fixed Coupon Product daily settlementcalculation;

FIG. 19 shows the Adapted For Exchange New Money Market Derivativesinvention flow diagram for Overnight Indexed and Fixed Rate OIS Productposition breakdown;

FIG. 20 shows the Adapted For Exchange New Money Market Derivativesinvention flow diagram for Overnight Indexed and Fixed Rate OIS Productdaily settlement and indexation calculation;

FIG. 21 shows the Exchange Traded Pooled Deposit Market Invention flowdiagram for mapping and reverse mapping; and

FIG. 22 shows a schematic Representation of the trading of ClearingHouse Securities.

DETAILED DESCRIPTION OF THE INVENTION AND OF THE PREFERRED EMBODIMENTSOverview of the Whole Invention

The invention consists of a number of linked innovations in productdesign, product management processes, pre and post trade systems design,product settlement processes and the role of the clearing house thatwhen applied to an existing electronic futures exchange lead to theestablishment of convenient on exchange access to spot and forwardderivatives normally only available on the ISDA based OTC market. Notall products will rely on all the innovations.

In addition an innovation which involves the role and business processesof the exchange's clearing house can also be extended to a number offurther inventive applications distinct from the trading of ISDA-likeproducts on exchange yet potentially extremely useful to the financialmarkets.

Introduction to the ISDA-Like Derivatives Product Exchange Part of theInvention Description of this Part of the Invention

Specifically the ISDA-like invention exists in three forms Adapted ForExchange New Credit Derivatives, Adapted For Exchange New Interest RateSwaps and Adapted For Exchange New Money Market Derivatives.

Novelty of this part of the invention

The invention can be clearly distinguished from all others which merelytry to create exchange-like electronic central market trading systemsand/or post trade clearing systems that remain within the ISDA based OTCmarkets' legal structure or analogues to it. Existing inventions of thisfirst type typically show no recognition of the advantages of thetraditional futures exchange model. There are numerous examples such asthose dealing with central markets for ISDA based products (e.g. thepatent application USPA 20040143535, Jul. 22, 2004) or those dealingwith counterparty credit arising from the ISDA market structure (e.g.the patent U.S. Pat. No. 5,802,499, Sep. 1, 1998) or those dealing withthe post-trade confirmation process so unnecessary in a futures marketmodel (e.g. the patent U.S. Pat. No. 6,274,000, Jun. 21, 2001).

The invention can also be clearly distinguished from all others whichmerely try to create genuine exchange traded futures that indirectlyreference the ISDA based OTC markets either via a cash fixing on thosemarkets or indeed via structured negotiable securities with ISDA basedproducts embedded in them e.g. via credit linked notes. Inventions ofthis type have typically shown complex innovations in product design andproduct settlement processes whilst retaining the historicallystraightforward link between pre and post trade of traditional futuresmarkets. A leading example of this approach is “Swapnote” (see thepatent U.S. Pat. No. 6,304,858 B1, Oct. 16, 2001 ) which although it istraded under license on the fully electronic futures exchanges of LIFFEand TIFFE would have been perfectly capable of being traded in the oldopen-outcry markets. It is basically an advanced type of cash settledbond future. There is also a more recent example involving credit linkedfutures which is nonetheless equally traditional and equally dependanton the ISDA market to provide a credit linked note underlying (see thepatent application USPA 20050080734, Apr. 14, 2005).

The invention can also be distinguished from certain already existingexchange traded futures which merely introduce convexity into thestandard futures environment in a non-parametrical and non time-valuedway e.g. interest rate futures and options as currently traded on theSydney Futures Exchange.

General Note on Novelty

The CFTC glossary on their web site has the following relevant entries:

Exchange: A central marketplace with established rules and regulationswhere buyers and sellers meet to trade futures and options contracts orsecurities. Exchanges include designated contract markets andderivatives transaction execution facilities.

Futures Contract: An agreement [on exchange] to purchase or sell acommodity for delivery in the future: (1) at a price that is determinedat initiation of the contract; (2) that obligates each party to thecontract to fulfil the contract at the specified price; (3) that is usedto assume or shift price risk; and (4) that may be satisfied by deliveryor offset.”

Traditional exchange derivatives (i.e. futures and options contracts)trading in a single product can therefore have been expected to alwaysresult in:

-   a single type of post trade contract (c.f. “An agreement”) but this    is not the case with the present invention.-   contracts that have a standard fixed notional term (c.f. “a    commodity for delivery” e.g. CME Three month Eurodollar) but this is    not the case with the present invention.-   either physical or cash settled deliverables (c.f. “by delivery or    offset” but not both) but this is not the case with the present    Adapted For Exchange New Credit Derivatives invention.-   a definite not merely a potential underlying delivery or offset    (c.f. “a commodity for delivery in the future” i.e. both the    commodity and the time of delivery are normally known at time of    trading) but this is not the case with the present Adapted For    Exchange New Credit Derivatives invention.

The invention is therefore clearly innovative in all these dimensions atthe least.

The General Advantages of this Part of the Invention

The object of this part of the invention is to give access to genuinelyISDA-like derivative exposures within a purely electronic futuresexchange-like environment. Two key points to notice about this inventionare:

-   Spot market—That it gives daily spot not forward exposure for the    first time on a futures exchange-like environment. Most ISDA based    credit, interest rate swaps and money market products are spot    derivatives not forwards. This means that they give exposure to the    relevant term structure from the very beginning of the curve. This    contrasts with futures which are analogous to ISDA based forwards.-   Flexibility—That it dramatically increases the flexibility of a    purely electronic futures exchange-like environment to play host to    products whose quotation value and tick value are not immediately    deducible from the quotation itself without reference to any    external variable parameters.

The general view has been historically that ISDA-like derivativeexposures cannot be transferred onto a genuine exchange. This inventionis significant in that it shows this perception to be wrong and that allthe advantages of a futures exchange-like environment can be brought tobear for a significant fraction of ISDA based products.

The advantages of using a genuine exchange for trading are readilyapparent from the “Background To The Invention” section above.Specifically the advantages include but are not necessarily limited bythe following:

-   Quasi-negotiable securities—By moving away from the current ISDA    based bilateral model onto a futures exchange-like environment the    products behave similarly to negotiable securities when viewed from    within the exchange's membership and clearing structure. However a    ‘transfer’ of title when it happens is in fact achieved by one    client closing their position with the clearing house while their    counterparty opens an identical new position.-   Robustly fair marketplace—The supervisory environment of a genuine    exchange is such that a customer is protected by the exchange's    trading rules and members are appropriately punished for breaches of    best practice conduct. Both the central marketplace at the exchange    and also the central depository at the exchange's clearing house    provide easy access to the audit trails required whenever an    investigation is commenced.-   Comprehensive access to central counterparty—Unlike certain existing    initiatives that seek to provide clearing and central counterparty    services within the ISDA based market the exchange's clearing house    will provide these services to all users of ISDA-like products based    on the invention. This is because it is impossible to access the    invention based products except via the exchange.-   Anonymous trading—The combination of a universal central    counterparty and electronic trading means that anonymous trading is    standard.-   Decreased systematic risk—Regulators and central banks have often    voiced concerns over the non transparent nature of the existing ISDA    based derivatives markets. The web of bilateral counterparty credit    exposures is so complex and vast that it is impossible to rule out a    domino effect of defaults via contagion within the financial system    should a major institution get into serious difficulties. A large    scale move to the alternatives created by ISDA-like products based    on the invention would eliminate these fears. Also in the event of    extreme financial stress there would be a single point of    application for the injection of funds from lenders of last resort,    namely into the exchange's clearing house.-   Decreased operational risks and costs—The legal and operational    structure of a genuine exchange decrease operational risks to a    minimum compared to the existing cumbersome ISDA based market. A    large scale move to the alternatives created by ISDA-like products    based on the invention would dramatically reduce costs as key    operational processes cease to be duplicated across the industry    instead becoming centralised.-   Efficient product structure—The legal structure of a genuine    exchange is such that all positions in a product exist by reference    to a master product specification. This allows the contract    specifications of all existing positions in a product to be    efficiently updated if necessary from time to time.-   Risk management via daily settlements—A key concern of regulators is    that derivatives positions may be mispriced by uninformed or indeed    fraudulent dealers within less sophisticated or indeed careless    financial institutions. The exchange's mark to market procedures via    daily settlements should greatly reduce this problem for internal    compliance officers of smaller or less sophisticated financial    institutions.-   Efficient counterparty structure—The legal structure of a genuine    exchange is such that access to all the exchanges products can be    achieved via any member that is allowed to offer such a service    under the exchange and clearing house rules and any other relevant    regulatory constraints. The prospective customer must simply sign a    single brokerage agreement with that member to access all products.-   Access via brokers—As many brokers are members of several different    exchanges a single brokerage agreement can give a customer access to    the entirety of exchange traded derivative products regardless of    exchange. Exchanges also typically allow customers to use a    different broker for execution purposes than for clearing purposes    via an assignment process called a “give up”. There is therefore a    broad competitive market for both execution and clearing brokerage    services which will typically result in low brokerage costs.-   Permission to trade—Many regulators recognise the high quality of    markets provided by exchanges in allowing broader access to them    than to the ISDA based market. In addition the rules of many funds    themselves forbid trading in OTC derivatives while allowing trading    on exchanges.-   Liquid and transparent central market—Historically for all the above    reasons those financial futures and options products that became    moderately successful on derivatives exchanges have gone on to    become extremely liquid indeed. Of course not all products are    successful. A significant uptake of the alternatives created by    ISDA-like products based on the invention seems likely to lead on to    a large scale move onto exchange and eventually far superior    liquidity than currently exists in ISDA based products.

Exchanges are thus by virtue of this revolutionary invention able tomimic the advantages of the existing ISDA based market whilst deepeningliquidity, broadening access and reducing operational, counterparty,legal and systematic risks. Two final points to note concern howrelatively undisruptive this invention can be:

-   OTC-style trading—Many exchanges have worked hard to offer    alternative access to their trade registration infrastructure via so    called wholesale trading facilities, including block trades and    basis trades. Wholesale trading facilities allow dealers to agree    transactions over the phone OTC-style and then register these in a    timely fashion as futures or options on the exchange. They are    particularly suited for transactions contingent on a cash trades or    transactions where liquidity is too limited to absorb a very large    order in a continuously quoted market or indeed wherever market    makers quote on an ad hoc basis. Thus where appropriate the new    ISDA-like products based on the invention can still be traded in an    OTC-style.-   Risk management—Intraday risk management systems will need very    little modification to deal with ISDA-like products based on the    invention rather than the existing ISDA based products they mimic.

Furthermore specific advantages are included in the relevant sectionsbelow.

Outline of System Changes Required for the ISDA-Like DerivativesExchange Part of the Invention

In traditional futures exchanges generally speaking contract quotationis identical for front office and back office purposes. Where occasionalexceptions to this rule do exist they consist of trivial or at leastdeterministic transformations taking no account of the actual term ofthe cash product underlying the traded derivative.

The present invention does away with this traditional futures exchangeconstraint thus allowing ISDA-like debt related products to be listed ona genuine exchange for the very first time. This is achieved viamodifications to the trade information flow diagram as shown in FIG. 8at the points indicated by the circles numbered 1-5.

FIG. 8 is essentially a modified version of FIG. 4. It therefore shows alogical representation of operational information flow in trading theadapted exchange based derivatives. Item 800 of FIG. 8 represents justone of the many dealers trading on the adapted exchange. The dealersdecisions will be informed by general activity observable across variousmarkets and news as published by quote vendors (see item 802 of FIG. 8).The dealer shown also has direct access to the market place and viatheir own front office trading system (see item 804 of FIG. 8). Thefront office trading system connects to the adapted exchange via a socalled exchange gateway (see item 808 of FIG. 8) which forms thephysical and logical boundary to the exchange maintained systems. Orderscan be placed in the matching engine (see item 814 of FIG. 8) in thehope that a counterparty can be found and valid half trades are enteredinto the trade registrations system (see item 818 of FIG. 8) and arepassed to the appropriate accounts within the clearing house (see item822 of FIG. 8). Market status information is calculated and published(see item 812 of FIG. 8) and monitored by the market supervisionfunction (see item 810 of FIG. 8) who also set the daily settlementprices (see item 820 of FIG. 8) used by the clearing house (see item 822of FIG. 8) which calculates variation margin calls to or from members(see item 816 of FIG. 8) and open interest (see item 824 of FIG. 8).Finally trading reports (see item 806 of FIG. 8) are produced by themember back office.

We now considered the modifications proposed by the present inventionwhich take the form of mappings and reverse mappings between threeseparate groups of products:

-   A front office product that is used on dealer trading and    information systems. The quotation convention here is the one most    suitable for the dealers in the product.-   An internal matching product that exists only within the    infrastructure of the electronic exchange. The representation here    is the one most suitable for the matching engine when combining    strategy and outright orders.-   One or more back office products that exists only within the    clearing infrastructure of the clearing house, it's members and the    dealer's back office. The representation here is the one most    suitable for expressing profit or loss and risk exposure.

Returning to FIG. 8 we see that each mapping exists between the boundaryof the above products at points indicated by circles numbered 1-5. Sincethe exact boundary is to some extent arbitrary the mappings can beimplemented in different places yet have the same effect. As shown:

-   1. Mapping 1 (see circle point 1 in FIG. 8) is a two way mapping    that converts the dealer's front office quotation orders into the    internal matching representation, and the dealer's fills back from    this representation into the front office product.-   2. Mapping 2 (see circle point 2 in FIG. 8) is similar to the    dealer's fills mapping but converts the whole order book from the    internal matching representation back into the front office product.-   3. Mapping 3 (see circle point 3 in FIG. 8) is the conversion from    the internal matching representation into the back office product.-   4. Mapping 4 (see circle point 4 in FIG. 8) is similar to the    dealer's orders mapping but converts wholesale trades agreed over    the telephone into the back office product representation directly.-   5. Mapping 5 (see circle point 5 in FIG. 8) is the conversion of    front office product settlement reference prices into actual back    office product daily settlement prices. The former are set by the    market supervisor each day from front office market activity on the    close but the latter are what are actually needed for variation    margin calls.

The details of the mappings will vary with the particular ISDA-likeinvention i.e. Adapted For Exchange New Credit Derivative or Adapted ForExchange New Interest Rate Swap or Adapted For Exchange New Money MarketDerivatives. Indeed not all the inventions require all the mappings. Themappings may also vary with the particular money market product. We nowgo on to describe the details of these mappings and the associatedproducts for each ISDA-like invention subset.

Reconciliation, Efficient Give Ups and Open Interest Markers

Where a product design leads a single front office trade to be splitinto several back office positions this may pose operationaldifficulties. It should be noted therefore that for reconciliationpurposes between front office and back office systems and for openinterest reporting purposes the preferred embodiment of the inventionwill conserve information appropriately.

It is envisaged that all front office product fill reports on a dealer'strading system (see item 804 of FIG. 8) are accompanied by the relevantback office product breakdowns to help with front office versus backoffice reconciliation.

It is also envisaged that front office product matched trades will bepassed through to the clearing house (see item 822 of FIG. 8). Thesematched front office trades will appear on the clearing house's traderegister as normal contracts simply for convenience. However theeconomic significance of these trades is carried by the associated backoffice products and not by these front office position markersthemselves e.g. matched front office trades will not be charged margin.

Front office position markers held at the clearing house can be used toassist with front office versus back office reconciliation. They willalso be used for calculating open interest reports (see item 824 of FIG.8) for front office systems. Another important usage is for efficientgive ups. The preferred embodiment of the invention will allow backoffice managers (see item 816 of FIG. 8) to give up and take in productsby reference to the front office position markers held in the clearinghouse's trade registration systems (see item 818 of FIG. 8) alone i.e.the associated back office products referenced to a particular frontoffice trade would be transferred as a group simply by transferringtheir front office position marker.

The Details of the Adapted for Exchange New Credit Derivatives InventionOverview

The Adapted For Exchange New Credit Derivatives invention fallsnaturally into two halves:

-   1. The Traded Credit Product that exists whether or not there is a    credit event; and-   2. The Event Protection Products and Processes that are created in    order to generate efficient credit protection if there is a credit    event.

Recovery Rate Products can be viewed as part of point 2 but could alsoin principle be listed independently to assist hedging in existing ISDAbased credit derivatives.

Advantages

Several of the advantages already mentioned in the general advantagessection will be of particular benefit in tackling barriers to growth inthe existing ISDA based Credit Derivatives market. For example greatbenefits can be expected in the following areas:

-   Permission to trade—Customer orders flowing towards large banks    within the existing ISDA based Credit Derivatives market are limited    by regulatory restrictions. In particular access tends to be    restricted from large but traditional funds. Often the managers of    such funds will nonetheless recognise the benefits of credit    derivatives, so if access were improved a significant uptake of the    invention would seem likely.-   Daily settlements and counterparty structure—Barriers to entry    caused by concerns over marking to market and other concerns    internal to smaller less sophisticated banks or large but    traditional funds are very large in the existing market. A    significant uptake of the invention therefore seems likely and will    result in slashed documentation overheads and middle office costs.-   Access via brokers—The existing ISDA based market has shown    tremendous growth even though it is relatively hard to access. The    Adapted For Exchange New Credit Derivatives invention will however    bring to bear the already broad and competitive network of futures    brokers and the already broad end user access to exchange trading    screens. A significant uptake of the invention therefore seems    likely and will result in reduced brokerage costs in the longer    term.-   Decreased operational risks and costs—No fully established straight    through processing standard exists in the current ISDA based market.    By contrast futures exchanges have had straight through processing    as part of their standard business model for decades. A significant    uptake of the invention therefore seems likely and will result in    slashed back office costs.

As a result of the above benefits as well as those set out below a stepchange in market turnover growth is likely to result.

Other advantages already mentioned in the previous section will resultin significant but less dramatic benefits over the existing ISDA basedmarket. Some examples of these include:

-   Quasi-negotiable securities—Although the new ISDA-like products    based on the invention will appear familiar to dealers used to    trading their ISDA based equivalents post trade anonymity will be    possible for the first time via the exchange's membership and    clearing structure. This should encourage larger orders to be    placed.-   Efficient product structure—The development of the existing ISDA    based Credit Derivatives documentation has been an iterative process    as the market gradually became aware of definitional issues that    might lead to legal and market risks. The need to refine    documentation will no doubt continue. A significant uptake of the    invention will result in the market benefiting from the exchange's    ability to efficiently update contract details of all open positions    in a product simultaneously if necessary.

The benefits already mentioned in this section are generally applicableto exchange traded derivatives although they may be of particularimportance for credit derivatives. However such benefits can only comeinto play when a workable Adapted For Exchange New Credit Derivativedesign exists.

In addition are benefits that result from the product designs, productmanagement processes, pre and post trade systems design, productsettlement processes and the enhanced role of the clearing house thatare specific to the Adapted For Exchange New Credit Derivativesinvention itself. Several other major weakness of the existing ISDAbased Credit Derivatives market are addressed by the invention. Theseadditional advantages include the following:

-   Legal certainty—In the ISDA based market legal costs can be    particularly high as credit events result in high value obligations    which are worth contesting in the courts if as a result payment can    be avoided. The Adapted For Exchange New Credit Derivatives    invention does not allow for such opportunistic legal challenges.-   Robustness in pricing—The product designs give both the convenience    of cash settlement and the robustness of physical delivery to market    participants. Also by virtue of the product designs certain    participants who cannot or do not want to take physical delivery are    insulated from the risk of delivery being made.-   Reference Obligations—The product designs bring to an end the need    for the trade confirmations that form an important part of the legal    structure of the existing bilaterally negotiated ISDA based market.    Trade confirmations are a particular problem for Credit Derivatives    where the reference obligation named by counterparties often do not    match exactly. The real problem is that the exact choice of    reference obligation is in many, but crucially not all, cases to    some extent arbitrary. This problem is completely eliminated by    virtue of the product designs which give the exchange sole authority    to define deliverable obligations.-   Central treatment of credit events—The product designs bring to an    end bilateral manual exercise of rights after a credit event.    Instead by virtue of the product designs the exchange has sole    authority to call a credit event.-   Consistent treatment of credit events—In the existing ISDA based    Credit Derivatives OTC market relative value trading can be affected    by definitional mismatches between deliverable obligations from the    same reference entity. Also cumbersome delivery cascades can result    from credit events being triggered. Such problems are eliminated in    the Adapted For Exchange New Credit Derivatives invention which    should therefore boost relative value and arbitrage trading    opportunities.-   Consistent treatment of credit events in options—In the existing    ISDA based Credit Derivatives OTC market, default swap options treat    credit events differently depending on whether the option have a    single name or multiple names underlying it. Single name European    style credit options are designed to help manage movements in the    spread not to give exposure to default itself and so they ‘knock    out’ if a credit event occurs in the referenced entity. By contrast    European style index options deliver the entire index upon exercise    at expiry to avoid complications close to expiry time but as a    result retain exposure to defaults themselves thereby creating the    potential for complexities arising further from expiry. Such    problems are eliminated in the Adapted For Exchange New Credit    Derivatives invention which should therefore boost credit index    option trading.-   Gaps in the term structure—Apart from the 5 year (and increasingly    10 year) point in the credit term structure the existing ISDA based    Credit Derivatives market is said to be illiquid. The product and    trade systems designs of the Adapted For Exchange New Credit    Derivatives invention will generate forwards and hence help create a    full credit term structure.-   Pure par credit spreads in and out—Cash adjustments are common    practice in the existing ISDA based Credit Derivatives market    whenever coupons have already been fixed e.g. when trading out of    existing single name positions or indeed when trading both in and    out of index positions. The cash adjustments are calculated using an    assumed recovery rate convention and this clouds the pure credit    exposure of the position. By contrast the product and trade systems    designs of the invention will generate pure par credit spreads in    and out.-   Six monthly index rollovers—Every six months the bulk of the index    market rolls from one index series to the next one but not all    positions are rolled. One embodiment of the invention solves the    problem of stale “off-the-run” series.

Traded Credit Products

The first part of the Adapted For Exchange New Credit Derivativesinvention is the Traded Credit Product which makes full use of the threerepresentations concept described in general terms above:

-   The front office product is called the Traded Spread Product (TSP)    that appears on trading and information systems is expressed in    annualised basis points according to market convention. The    quotation convention here is the one most suitable for showing this    product's relationship to the spread between risky and riskless    (i.e. government) debt. The Traded Spread Product can be traded as    spot or forwards along the credit term structure.-   The Internal Matching Product is basically the full de-annualised    premium expressed in price percentage points and allows the simply    creation of front office forwards using existing exchange implied    book matching technology.-   The back office product is the splitting of the Internal Matching    Product into so called Credit Coupon Products (CCPs) for the    clearing house etc. Credit Coupon Products are particularly suitable    for making sure forward trades are margined efficiently.

There are many varieties of the Traded Credit Product depending on theprotection exposure they yield if a credit event occurs i.e. dependingon the Event Protection Products that are created by them. These includebut are not limited to:

-   Single name traded spreads-   Industry standard indices and their sector indices-   Nth to default baskets and standard indices-   Tranched standard indices and synthetic CDOs-   Resetting Indices

However all these Traded Credit Products have basically the samestructure.

When on exchange options of the above are also consider it becomes clearthat Adapted For Exchange New Credit Derivatives can give dealersequally and possibly more comprehensive exposure to leveraged creditsthan does the existing ISDA based market.

Constituent Products Design Overview

Item 900 of FIG. 9 shows how a traded credit product might appear in thefront office as a Traded Spread Product. Contract volume available onthe bid and offer are not shown in the Figure but as with other exchangetraded contracts the Traded Spread Product will have a standard notionalunit of trading (e.g. $1 mln,

1 mln etc).

The Traded Spread Products also obey a standard listing and expirycycle. As the ISDA based market has already standardised to a largeextent the appropriate listing cycle will mirror this i.e. ten years ofproducts available for trading via March and September expiries plus oneadditional quarterly month so the nearest three expiry months areconsecutive quarterly expiries. The market convention is that defaultprotection expires on the twentieth calendar day of the expiry month orif such a day is not a business day on the next following business day.

Both the Internal Matching Products and Credit Coupon Products followthe same expiry cycle as the Traded Spread Products obey but include allconsecutive quarterly expiries i.e. March, June, September and Decemberand not just March and September plus one additional quarterly monthexpiry at the front of the curve.

In any exchange traded product concentration of liquidity is animportant by-product of standardisation. One part of standardisation isthe tick size which is the minimum price increment between differentorder price levels. The preferred embodiment of the Adapted For ExchangeNew Credit Derivatives invention has an orderbook tick size to helpconcentrate liquidity and displayed implied orders.

Two Step Implied Order Linkage in the Traded Spread Product

Consider a dealer interacting with the market as shown in FIG. 9 bylifting the 18.00 basis points per annum offer 25 times in the March2006 expiry. The dealer would be buying 169 days worth of protectionfrom 3 Oct. 2005 to 20 Mar 2006 on the relevant credit in $25 mln,assuming a standard notional unit of $1 mln. Conversely if the samedealer hit the 22.50 basis points per annum bid 25 times in theSeptember 2006 expiry they would have sold 353 days of protection in $25mln. The dealer is then net neutral for the first 169 days but a sellerof protection for the next 184 days i.e. he has sold the March2006/September 2006 forward.

One of the stated advantages of the Adapted For Exchange New CreditDerivatives invention is that the product and trade systems designs willgenerate forwards automatically and hence help create a full credit termstructure. This is achieved by harnessing in a novel way the impliedorder book technology already available for certain existing electronicfutures exchanges via the mappings that will shortly be described below.Thus the dealer could have simply placed an order to hit the 26.50 bidalso shown in FIG. 9 25 times to sell the same March 2006/September 2006forward directly.

Unlike existing exchange traded products the orderbook tick size doesnot apply beyond front office orderbook purposes and in particular doesnot apply to filled orders. This allows the spot and forward markets inTraded Spread Products to be properly linked via the internal matchingrepresentation's implied orderbook. Thus if the dealer places the orderto hit the March 2006/September 2006 forward directly as described abovethey would probably get an improvement to at least 26.633 (or better ifit was available in the actual implied order book). The relevantmappings to achieve this will shortly be described below.

Traded Spread Product, Internal Matching Product, Credit Coupon Productand Associated Mappings

The mappings that are part of the Traded Credit Product link the frontoffice Traded Spread Product with the back office Credit Coupon Productvia the Internal Matching Product as already described in general termsabove. We now turn to specifics and describe these with reference toFIG. 8 where each mapping exists between the boundary of the threesub-products at points indicated by circles numbered 1-5.

Mapping 1—Inbound

Mapping 1 occurs at the numbered circle point 1 in FIG. 8.

FIG. 10 shows the details of the inbound mapping process as applied tothe dealer's front office Traded Spread Product Orders (see 1000 of FIG.10) which turns them into Internal Matching Product Orders (either 1008or 1010 of FIG. 10). The first step consists of an initial check thatthe Traded Spread Product Order obeys the orderbook tick size as shownin branch point 1002 of FIG. 10 and if not the order is rejected asshown in endpoint 1004 of FIG. 10. If the orderbook tick size islegitimate there is next a branch point depending on whether the orderis for the spot or a forward market (see 1006 of FIG. 10).

Traded Spread Product Orders (TSOs) that are spot orders are mapped ontooutright Internal Matching Product Orders (IMOs) as outright orders andas follows (see 1008 of FIG. 10):IMO Lot volume=TSO Lot volumeIF TSO=Buy THEN IMO=Buy, ELSE IF TSO=Sell THEN IMO=SellDefine, Relevant Days=Expiry Date−Trade Date+1IMO Price %=(TSO Price/100)*(SNP %)*(Relevant Days)/360

However Traded Spread Product Orders (TSOs) that are forward orders aremapped onto Internal Matching Product Orders (IMOs) as calendar spreadstrategy orders and as follows (see 1010 of FIG. 10):IMO Lot volume=TSO Lot volumeIF TSO=Buy THEN IMO=Sell, ELSE IF TSO=Sell THEN IMO=BuyDefine, Relevant Days=Back Expiry Date−Front Expiry DateIMO Price %=−1*(TSO Price/100)*(SNP %)*(Relevant Days)/360

The mappings have to be parameterised by the expiry dates of theproducts, the trade date and the Surviving Notional Principal (SNP) asstored in dynamic databases shown as 1012 and 1014 of FIG. 10respectively. The SNP starts at 100% and drops after each notionalcredit event in the underlying basket or index. It is described in moredetail later when we describe notional credit events. It is also notreally relevant for the single name version of the Traded Credit Productwhere it can be taken to be 100% prior to a credit event having occurredand 0% after.

Mapping 1—Outbound Orderbook Reporting

Mapping 1 occurs at the numbered circle point 1 in FIG. 8.

FIG. 11 shows the details of the outbound orderbook mapping whichconverts each Internal Matching Product Orderbook Element (see 1100 ofFIG. 11) into a Traded Spread Product Orderbook Element (either 1112 or1114 of FIG. 11) for display purposes.

The first step is a branch point depending on whether the orderbookelement is an outright or a calendar spread strategy order (see 1102 ofFIG. 11). This is because there is a different mapping depending onwhether, an outright Internal Matching Product Orderbook Element (IMOE)is being converted into the relevant spot Traded Spread ProductOrderbook Element (TSOE), see 1104 of FIG. 11:TSOE Lot volume=IMOE Lot volumeIF IMOE=Buy THEN TSOE=Buy, ELSE IF IMOE=Sell THEN TSOE=SellDefine, Relevant Days=Expiry Date−Trade Date+1TSOE Price=(100*IMOE Price %)*360/(Relevant Days)/(SNP %)or whether a calendar spread Internal Matching Product Orderbook Element(IMOE) is being converted into the relevant forward Traded SpreadProduct Orderbook Element (TSOE), see 1106 of FIG. 11:TSOE Lot volume=IMOE Lot volumeIF IMOE=Buy THEN TSOE=Sell, ELSE IF IMOE=Sell THEN TSOE=BuyRelevant Days=Back Expiry Date−Front Expiry DateTSOE Price=−1*(100*IMOE Price %)*360/(Relevant Days)/(SNP %)

As for the inbound mapping already described the two different mappingshave to once again be parameterised by the expiry dates of the products,the trade date and the Surviving Notional Principal (SNP) as stored indynamic databases shown as 1108 and 1110 of FIG. 11 respectively.

In either case there is a final rounding and aggregation step to makeTraded Spread Product Orderbook Elements aggregate and appear to respectthe orderbook tick size for front office display purposes which dependson whether the displayed orderbook element is a buy or a sell (see 1116of FIG. 11). Bid prices are rounded down and volumes aggregated (see1112 of FIG. 11):

-   -   1. Round down the Traded Spread Product Orderbook Element price        of bids for front office display purposes to the nearest whole        traded spread orderbook tick.    -   2. Aggregate lot volume from different rounded Traded Spread        Product Orderbook Elements if they have been rounded to the same        front office display price to give total volume on that price

Offer prices are rounded up and volumes aggregated (see 1114 of FIG.11):

-   -   1. Round up the Traded Spread Product Orderbook Element price of        offers for front office display purposes to the nearest whole        traded spread orderbook tick.    -   2. Aggregate lot volume from different rounded Traded Spread        Product Orderbook Elements if they have been rounded to the same        front office display price to give total volume at that price

Mapping 1—Outbound Filled Orders

Mapping 1 occurs at the numbered circle point 1 in FIG. 8.

The outbound filled orders mapping converts order fills in the InternalMatching Product into front office fill reports in the Traded SpreadProduct. FIG. 12 shows the details of the outbound filled order mappingwhich converts each Internal Matching Filled Element (see 1200 of FIG.12) into a Traded Spread Product fill (see 1210 of FIG. 12) for displaypurposes. It is essentially the same mapping as the outbound orderbookone minus the final rounding and aggregation step, but carryingadditional information to help with front office versus back officereconciliation where relevant.

The first step is a branch point depending on whether the filled elementis an outright or a calendar spread strategy order (see 1202 of FIG.12). This is because there is a different mapping depending on whether,an outright Internal Matching Filled Element is being converted into therelevant spot Traded Spread Product Filled Element (see 1204 of FIG.12), or whether a calendar spread Internal Matching Filled Element isbeing converted into the relevant forward Traded Spread Product FilledElement (see 1206 of FIG. 12). As for the other mapping alreadydescribed both these mappings have to be parameterised by the expirydates of the products, the trade date and the Surviving NotionalPrincipal (SNP) as stored in dynamic databases shown as 1208 and 1210 ofFIG. 12 respectively.

Mapping 2

Mapping 2 occurs at the numbered circle point 2 in FIG. 8.

This is identical to the first outbound mapping at numbered circle point1 in FIG. 8 but for quote vendor screens. FIG. 11 shows the details.

Mapping 3

Mapping 3 occurs at the numbered circle point 3 in FIG. 8.

This is the conversion from the Internal Matching Product into therelevant back office Credit Coupon Products. It is typically a one tomany mapping and is basically the splitting of the full de-annualisedpremium represented by the Internal Matching Product into an equal totalpremium value of Credit Coupon Products. As long as total premium valueis unaltered by the split the details of the mapping do not actuallymatter too much.

FIG. 13 shows for example the pro rata Credit Coupon Product pricingbreakdown converting the Internal Matching Filled Element shown as item1300 in FIG. 13, into the relevant Credit Coupon Products shown as a setspanned by 1306 and 1308 in FIG. 13. The mapping itself is detailed inmodule 1304 in FIG. 13 which is parameterised as usual by the expirydates of the products and the trade date as stored in database shown as1302 in FIG. 13, the Surviving Notional Principal (SNP) having beenalready incorporated indirectly at time of matching. The advantage ofthis technique is that partial fills of Traded Spread Product Orderswill all have the same leg prices for their respective Credit CouponProducts.

If a sequence of instantaneous reference prices is available from thematching engine and that sequence covers the whole Credit Coupon Productsequence (possibly using interpolation) then the pricing breakdownmethod shown in FIG. 14 can be applied instead. This more advancedtechnique converts the Internal Matching Filled Element shown as item1400 in FIG. 14, into the relevant Credit Coupon Products shown as a setspanned by 1406 and 1408 in FIG. 14. The mapping itself is detailed inmodule 1404 in FIG. 14 and is parameterised by the sequence of real-timereference prices shown as 1402 in FIG. 14, which already incorporatedindirectly the expiry dates of the products, the trade date and theSurviving Notional Principal as they are related to the current TradedSpread Product market in the same way that daily settlement prices arerelated to the Traded Spread Product market on the close, see Mapping 5below. The advantage of this technique is that traded leg prices forCredit Coupon Products will show less scatter and hence containinformation suitable for front office predictive and historicalanalysis.

Mapping 4

Mapping 4 occurs at the numbered circle point 4 in FIG. 8.

This is identical to the inbound mapping at numbered circle point 1followed immediately by the mapping at numbered circle point 3 in FIG.8. It is used to convert wholesale trades agreed over the telephone intothe back office representation directly.

Mapping 5

Mapping 5 occurs at the numbered circle point 5 in FIG. 8.

FIG. 15 shows the details of the mapping which converts of the set offront office Traded Spread Product Daily Reference Prices (TSDRP_(i)) asset by the market supervisor (see 1500 in FIG. 15) into the actual backoffice Credit Coupon Product daily settlement prices (CCPDSP_(i)) neededfor variation margin calls (shown as spanned by 1510 through to 1512 inFIG. 15). The Traded Spread Product daily reference prices do not needto respect the orderbook tick size. The conversion mapping is of courseonce again parameterised by the expiry dates of the products, the tradedate and the Surviving Notional Principal (SNP) as stored in dynamicdatabases shown as 1502 and 1504 of FIG. 15 respectively.

The first step is to interpolate any missing TSDRPi's so the expirysequence matches Credit Coupon Product sequence (see 1506 in FIG. 15).This is needed as most June or Dec expiries are not listed for frontoffice or matching purposes in the preferred embodiments of theinvention.

The mapping itself is shown as module 1506 in FIG. 15. Thus for thefirst quarterly expiry (i=1):Relevant Days=1st CCP Expiry Date−Trade Date+1CCPDSP ₁%=(TSDRP ₁/100)*(SNP %)*(Relevant Days)/360

Whilst for all other quarterly expiries up to the maximum listedRelevant Days=ith CCP Expiry Date=31 Trade Date+1CCPDSP _(i)%=(TSDRP _(i)/100)*(SNP %)*(Relevant Days)/360−Sum{CCPDSP_(j)%, j=1 to i}

The mapping is essentially a bootstrapping combination of the inboundmapping at numbered circle point 1 and the FIG. 14 version of themapping at numbered circle point 4 in FIG. 8 including an initialinterpolation step to ensure a full sequence of Traded Spread Productsettlement prices is available.

Daily Remapping of GTC Orders

This mapping occurs within the matching engine and its associateddatabases.

Because the mappings linking Traded Spread Product orders with InternalMatching Product orders are parameterised by the expiry date of theproducts, the trade date and the Surviving Notional Principal thepersistence of Good Till Cancelled (GTC) Traded Spread Product ordersmust be handled carefully. Specifically these orders should be storedovernight in their Traded Spread Product order format and remapped intoInternal Matching Product orders with the revised daily parameters priorto the open of each following trading day.

Expiry of Credit Coupon Product

Each Credit Coupon Product is a cash settled product (see FIG. 5 ) butwith the unique feature that its Expiry Day Settlement Price (see 506 ofFIG. 5) is predefined to be exactly zero and not linked by a formula toany external underlying market fixing. The Credit Coupon Product's valuearises from the fact that it confers ownership rights of EventProtection Products that are created in order to generate efficientcredit protection if there is a credit event. We discuss these EventProtection Products and Processes in the next section.

Event Protection Products and Processes

The second part of the Adapted For Exchange New Credit Derivativesinvention is formed from the event protection products and processeswhich generate credit protection far more efficiently than the existingISDA based market. These are shown schematically in overview in FIG. 16.

Credit Event Committee and the Calling of Notional Credit Events etc

The Adapted For Exchange New Credit Derivatives invention depends oncertain key product management processes namely the Credit EventCommittee (CEC) (see 1600 of FIG. 16) and the Notional Credit Events(NCEs) (see 1604 of FIG. 16) it calls.

The Credit Event Committee is a body established by the Exchange incooperation with significant market participants in a) the existing ISDAbased market such as the shareholder banks of the IIC and CDS IndexCo;and b) the Adapted For Exchange New Credit Derivatives made possible bythe invention.

The Credit Event Committee will generate and from time to time reviseits own definitions, rules and principles concerning credit events thatare nonetheless analogous to those existing in the current ISDA CreditDerivatives Definitions document (see 1602 of FIG. 16).

The Credit Event Committee in cooperation with open interest holderscontinuously monitor the entities referenced by Traded Credit Productslisted on the Exchange and its Clearing House. By use of its owndefinitions, rules and principles concerning credit events but in anycase entirely at its own discretion the Credit Event Committee willdecide if and when a Notional Credit Event has been triggered (see 1604of FIG. 16).

The Notional Credit Event decision is defined as final in the contractspecification and cannot be changed. Dealers are generally aware of thefact, but in any case are obliged by the contract specification toaccept the risk, that Notional Credit Events and “real” (or ISDAdefined) credit events are technically distinct.

Since by the act of trading on Exchange dealers accept the risk that aNotional Credit Event may be called by the Credit Event Committee“inappropriately” the Adapted For Exchange New Credit Derivativesinvention does not allow for legal challenges arising from the detailsof such credit events. This is a highly significant advantage over theexisting ISDA based market but does put a heavy onus on the Credit EventCommittee to develop a strong reputation as a trusted “calculatingagent” of whether a credit event has occurred.

It should also be noted that the use of the Credit Event Committee as acentral authority to call a Notional Credit Events is operationally farmore efficient than the bilateral manual exercise of rights after acredit event that exists in the current ISDA based market. Since therecan be several different Traded Credit Products listed on a singlereferenced entity, a single Notional Credit Event can affect a group ofdistinct products listed on the Exchange and its Clearing House in aconsistent way (see for example products 1606, 1610, 1616, 1622, 1628and 1634 of FIG. 16). This is also far more operationally efficient thanexisting ISDA based market.

The Credit Event Committee's definitions, rules and principles (see 1602of FIG. 16) will also explain how the list of deliverables is set forthe Recovery Auction Product or Recovery Rate Product (see 1606 of FIG.16) as described below following a Notional Credit Event (see 1604 ofFIG. 16). Thus the committee also acts as a trusted third party“calculating agent” for consequent obligations of derivative positionholders after an event is called. By contrast the bilaterally negotiatedISDA based market places strong emphasis and often redundant effort inpredefining reference obligations for what in practice often turn out tobe strictly operational rather than economic purposes. This representsanother important advantage of the Adapted For Exchange New CreditDerivatives invention over the existing market structure.

Consequences of Notional Credit Events

Regardless at what time of day a Notional Credit Events is announced inthe preferred embodiment nothing happens until overnight after themarket shuts normally. There are three immediate consequences of aNotional Credit Event:

-   -   a. The assignment of the correct number and type of Event        Protection Futures (EPFs) to each effective Credit Coupon        Product holder (see for example products 1614, 1620, 1626, 1632        and 1638 of FIG. 16); and    -   b. The de-listing where relevant of Traded Spread Products with        a final mark to market of the corresponding Credit Coupon        Product to exactly zero (see 1612 of FIG. 16); and    -   c. The reduction of each Surviving Notional Principal (SNP)        number for each basket, index, sector index or synthetic CDO        that includes the relevant reference entity (see for example        products 1618, 1624, 1630 and 1636 of FIG. 16). Thus a Notional        Credit Event one name from within an equally weighted 125 name        index will result in that index's SNP dropping by 0.8%=        1/125^(th) e.g. from 100% to 99.2%.

The role of the Credit Event Committee's as a trusted third party“calculating agent” may be contrasted against automatic options exercisein the existing exchange traded futures and options market (see FIG. 7)where the exchange acts as “calculating agent” of the reference prices(see 700 of FIG. 7), which though a far simpler calculation isnonetheless the closest analogous process prior to the present invention

Assignment of Event Protection Future

Event Protection Futures are cash settled products (see FIG. 5 ) withthe unique feature that Expiry Day Settlement Price (see 506 of FIG. 5)is defined with reference to another physically delivered exchangetraded product namely the Recovery Auction or Rate Product (see 1606 ofFIG. 16).

The exact EDSP formulae will be explained in a later section but here wediscuss the assignment process. Event Protection Futures positions areonly ever assigned to the ‘effective’ Credit Coupon Product i.e. to thefront expiry on the day the Notional Credit Event is called. Holders oflong positions in the effective Credit Coupon Product receive longpositions in Event Protection Futures from the holders of shortpositions in the effective Credit Coupon Product who take thecorresponding short positions in Event Protection Futures. The EventProtection Futures are assigned at zero price on the day after theNotional Credit Event is called. These facts have important consequencesfor margin efficiency which we will discuss in due course.

The assignment of the correct number of Event Protection Futures to eacheffective Credit Coupon Product is based on the notional size ofcontracts and the weight of the reference entity in the basketunderlying the particular Credit Coupon Product (obviously theweight=100% for single names):Number of EPFs long=Number of effective CCP lots long*weight*NotionalCCP lot size/Notional EPF size

In the case of an equally weighted 125 name index, the reference entityweight would be 0.8% of original notional for each name within theindex. Assuming a standard notional unit of $1 mln for the Credit CouponProduct and $1,000 for the Event Protection Futures, we can see that 8lots of Event Protection Futures will be assigned to every 1 lot ofCredit Coupon Product on the day after the Notional Credit Event occurs.

The overnight assignment of Event Protection Futures to each effectiveCredit Coupon Product is an important design feature that allows nextday trading of basket Traded Spread Product ‘clean’ of the NotionalCredit Event.

Recovery Auction Product

A Recovery Auction Product is a bond-like physically delivered exchangetraded product (see FIG. 6). Unusual features include the fact that theRecovery Auction Product a) is listed only as a result of a NotionalCredit Event; and b) is listed for only a short single trading day afixed number of business days after the Notional Credit Event; and c)can in principle contain loans in its list of deliverables as well asbonds; and d) has all the conversion factors in its list of deliverablesset to exactly 1.

The initial list of deliverables with accrued interest (see 612 of FIG.6) is published as soon as possible after the Notional Credit Event (see1604 of FIG. 16) is announced and the final list of deliverables withaccrued interest (see 608 of FIG. 6) is published the day before theRecovery Auction Product is listed for trading. Indeed the fixed numberof business days after the Notional Credit Event defining when aRecovery Auction Product is listed for trading will have been set incooperation with the market by the Credit Event Committee in itsdefinitions, rules and principles (see 1602 of FIG. 16) concerningcredit events so as to allow sufficient time for market feedback (see610 of FIG. 6).

The deliverability of loans will be discussed as part of the details ofthe clearing house securities part of the invention section below.

The Exchange Delivery Settlement Price for a Recovery Auction Productmay be used to cash settle Event Protection Futures (the productsassigned at 1614, 1620, 1626, 1632 and 1638 in FIG. 16) either directlyor for certain basket products indirectly via Total Event Loss Indices(see 1608 of FIG. 16) as described in detail below.

Recovery Rate Product

The Recovery Rate Product is a variant of the Recovery Auction Productthat is listed for trading even before a Notional Credit Event and hasno pre-set expiry date. The Recovery Rate Product's expiry date onlybecomes set after a Notional Credit Event happens according to thedefinitions, rules and principles concerning credit events as laid downby the Credit Event Committee from time to time.

As with Recovery Auction Products the initial and then the final list ofdeliverables for The Recovery Rate Product are only announced after theNotional Credit Event but always so as to allow sufficient time formarket feedback.

Where an pre-existing Recovery Rate Product is already listed TheExchange Delivery Settlement Price needed to provide fair cashsettlement Event Protection Futures will be set by reference to thatexisting product and no Recovery Auction Product need be listed.

EDSP of Event Protection Futures

There are two kinds Event Protection Futures known as the Standard andAttached forms.

Standard Event Protection Futures (SEPF) are designed to give fullprotection and are delivered into non-tranched Traded Credit Products.Their EDSP (see 506 of FIG. 5) is given by:SEPF EDSP=Max(100−EDSP of Recovery Product, 0)in which the Max function serves to prevent the Event Protection Futuresever giving negative protection.

By contrast an Attached Event Protection Future is designed to giveprotection only after a certain threshold of principal has been exposedto loss for the underlying basket, index, sector index or synthetic CDO.Because of these thresholds we will now need to define a Total EventLoss Index (TELI) number for each index or basket etc for whichthresholds will be relevant.

Total Event Loss Indices depend on the historic EDSPs of the RecoveryAuction or Rate Products referenced by each index or basket etc as shownschematically in item 1608 of FIG. 16. When a new basket is officiallylaunched its TELI starts at 0% and is just the sum of the Max(100−EDSPof Recovery Product, 0) terms already described above multiplied by theweight of the relevant reference entity in the basket for all theRecovery Auction or Rate Products that have occurred since the basket'slaunch i.e.TELI for basket=Sum{Max(100−EDSP of Recovery Product, 0)*weight ofentity}

The TELI is used as described in detail below.

For Attached Event Protection Future the threshold is known as theattachment point. Their EDSP (see 506 of FIG. 5) is given by:AEPF EDSP for basket=Max(new TELI−Max(Attachment Point, old TELI),0)/weight of reference entity in the basketin which The old TELI is just the Total Event Loss Index as it stoodbefore the latest Recovery Auction or Rate Product EDSP whilst the newTELI includes the latest Recovery Auction or Rate Product EDSP.

Once the old TELI exceeds the attachment point the Attached EventProtection Future behaves exactly like a Standard Event ProtectionFuture so under these circumstances the preferred embodiment of theAdapted For Exchange New Credit Derivatives invention will allow theclearing house to net off standard Traded Credit Products and therelevant attached Traded Credit Products for margin efficiency.

In the current ISDA based market tranched products are very common. Atranched product has both an attachment point and a detachment pointwhich is a threshold above which protection ceases. We have describedonly Attached Event Protection Futures as this is the preferredembodiment of the invention with tranched products being created fromlong versus short spread positions of attached products with differentattachment points. Attached Event Protection Futures will thereforedelivered into both attached and tranched Traded Credit Products.

Varieties of Adapted for Exchange New Credit Derivatives

As already stated there are many varieties of the Traded Credit Productdepending on the protection exposure they yield if a credit event occursi.e. depending on the Event Protection Products that are created bythem. There are also some useful variants of the Recovery Rate Productto consider. The following is a survey of some of these different kindsof product.

Single Name Traded Credit Products

Single name Credit Default Swaps form the majority of trading activityin the existing ISDA based market. Single name Traded Spread Productswill be de-listed after a Notional Credit Event in the reference name,Standard Event Protection Futures will be delivered against the relevanteffective Credit Coupon Product positions and all relevant Credit CouponProducts will be expired early with EDSP set to exactly zero as usual.After the fixed number of business days defined in the Credit EventCommittee's definitions, rules and principles the Recovery Auction orRate Product will expire and the required EDSP will be set.

Explicit Name Recovery Rate Products

In today's existing OTC market participants have tried to create anactive market in so called recovery swaps to meet genuine hedging needbut trading has failed to take off due to design and market structureissues. Explicit Name Recovery Rate Products are simply Recovery RateProducts as already described previously for which the underlyingreference entity is fully specified explicitly at time of listing. Theseproducts and especially the options on them described below shouldbetter meet the needs of hedgers than the existing moribund recoveryswaps market.

Standard Index and Sector Traded Credit Products

An obvious first application of the Adapted For Exchange New CreditDerivatives invention would be the listing of indices such as the DowJones CDX North America and iTraxx Europe.

A probable next step would be to list sub-sectors of these indices i.e.Autos, Consumer cyclicals, Consumer non-cyclicals, Energy, Industrials,Financials, Non-Financials and TMT. In the preferred embodiment of theinvention sector Traded Credit Products would have notional contractsizes commensurate with the main index of which they form a part inorder to facilitate spread trading. Thus for example a 1 lot short mainindex position versus a full set of 1 lot long sub-sector indices wouldcarry zero event risk by design and would attract minimal or zeroinitial margin.

Index and sub-index Traded Credit Products will have their SurvivingNotional Principal number reduced appropriately after a Notional CreditEvent in a relevant reference entity and Standard Event ProtectionFutures will be delivered against the relevant effective Credit CouponProduct positions. After the fixed number of business days defined inthe Credit Event Committee's definitions, rules and principles theRecovery Auction or Rate Product will expire and the required EDSP willbe set.

Nth to Default Basket Traded Credit Products

1^(st) to default, 2^(nd) to default, 3^(rd) to default etc TradedCredit Products on baskets or indices of reference entities are commonin the existing ISDA based market. They can of course just as easily betraded by application of the Adapted For Exchange New Credit Derivativesinvention.

For an equally weighted index the different N^(th) to default TradedCredit Products will have predefined Surviving Notional Principalnumbers from when they were first listed. For example for N^(th) todefault Traded Credit Products on an equally weighted 125 name index the1^(st) to default Traded Credit Products will have an SNP of 100%, the2_(nd) to default Traded Credit Products will have an SNP of 99.2%, the3^(rd) to default Traded Credit Products will have an SNP of 98.4%, etc.

After a Notional Credit Event in the N^(th) relevant reference entitythe N^(th) to default Traded Spread Products will be de-listed, StandardEvent Protection Futures will be delivered against the relevanteffective Credit Coupon Product positions and all relevant Credit CouponProducts will be expired early with EDSP set to exactly zero as usual.After the fixed number of business days defined in the Credit EventCommittee's definitions, rules and principles the Recovery Auction orRate Product will expire and the required EDSP will be set.

Tranched Index and Synthetic CDO Traded Credit Products

Synthetic CDOs were discussed in the background to the invention sectionand are clearly closely related to tranched index products. A fulldiscussion of CDOs will be included as part of the details of theclearing house securities part of the invention section below.

The preferred embodiment of the invention has tranched Traded CreditProducts being created from long versus short spread positions ofAttached Traded Credit Products with different attachment points.

The index or sub-index on which Attached Traded Credit Products arelisted will have its Surviving Notional Principal number reducedappropriately after a Notional Credit Event in a relevant referenceentity. Also Attached Event Protection Futures appropriate to thedefined attachment point will be delivered against the relevanteffective Attached Credit Coupon Product positions. After the fixednumber of business days defined in the Credit Event Committee'sdefinitions, rules and principles the Recovery Auction or Rate Productwill expire and the required EDSP will be set. This will be used toupdate the index or sub-index Total Event Loss Index number allowing theAttached Event Protection Futures to cash settle to their EDSP. Finallyif the new Total Event Loss Index number exceeds the attachment pointfor listed Attached Traded Credit Products the clearing house willde-list them transferring all open Attached Credit Coupon Productpositions and GTC orders into standard Traded Credit Products and allownetting to occur where possible.

Resetting Index Traded Credit Products

Every six months the bulk of the existing ISDA based index market isencouraged by market makers to roll from one index series to the nextone. However not all positions are in fact rolled leading to older“off-the-run” series having to be operationally maintained in riskmanagement systems etc until these stale positions expire. This costsresources for little practical benefit.

One embodiment of the invention is called the Resetting Index TradedCredit Product and solves the problem of stale off-the-run series bydefining an index's current constituent names plus substitutes in theevent of names dropping out after Notional Credit Events. As the oldeffective Resetting Index Credit Coupon Product expires the nexteffective Resetting Index Credit Coupon Product will reference theindex's composition as it existed on at this date. Thus underlying indexremains undefined until the effective date and is not set in advance onthe date that the index was first created.

This Resetting Index Traded Credit Product will thus automatically keeptrack of changes in the index composition and will not need to berolled. The design means that the Surviving Notional Principal numberwill only apply to mappings involving the effective Credit CouponProduct with all other Resetting Index Credit Coupon Products using 100%instead of the Surviving Notional Principal number. Also the SurvivingNotional Principal number will be reset to 100% as each new effectiveCredit Coupon Product is finally referenced to the index's compositionon its effective date. Otherwise this type of index product and itssub-sectors behave just like standard indices.

Tranched and N^(th) to Default Products

Tranched products are not really possible with the Resetting IndexTraded Credit Product design but variants of N^(th) to default productsare.

Implicit Name Recovery Rate Products

In today's existing OTC market participants have tried to create anactive market in so called recovery swaps to meet genuine hedging needbut trading has failed to take off due to design and market structureissues. The market has certainly not evolved beyond the point where theunderlying reference entity is not full defined and only knownimplicitly at time of trade. However we anticipate a hedging need fortraders of N^(th) to default Traded Credit Products on baskets orindices of reference entities. Implicit Name Recovery Rate Products aretherefore Recovery Rate Products as already described previously forwhich the underlying reference entity is not fully specified at time oflisting. For example using a 1^(st) to default Recovery Rate Productwill allow traders to take a view on the recovery rate of the firstreference entity to default within a given basket or index or sectorindex etc. These products and especially the options on them describedbelow should better meet the needs of hedgers than the existing moribundrecovery swaps market.

Traded Spread Options

Options on the Traded Spread Product are another possible extension ofthe listing of Traded Credit Products. Of the possible designs both cashsettled and deliverable European style options on forward ResettingIndex Traded Spreads (or equivalently on options referencing the index'scomposition as prevailing at expiry) are likely to be attractive to themarket as they neither suffer from adverse premium loss after or excessvolatility just before a Notional Credit Event in a relevant referenceentity is announced.

Traded Spread Premium Protected Options

Similarly so called Premium Protected Knock Out Options on single nameTraded Credit Products should be popular because of the premium returnfeature. As with normal options the time value component of the premiumwill decay as expiry approach whilst the intrinsic value will be afunction of the prevailing spread. These products are designed to copewith the complication that after a credit event a single name TradedSpread Product effectively ceases to exist and is replaced by itscorresponding Event Protection Future. There is therefore a ‘knock out’if a credit event occurs in the referenced entity but as the nameimplies for Premium Protected Options no premium is lost at this pointas a result of the knock out. This can be achieved in the exchangelisted environment because Premium Protected Options can be traded inmargined premium and not premium paid format there. Specifically thePremium Protected Knock Out Options simply expires early with no furthervariation margin calls being imposed, rather than the final variationmargin call to zero that would be expected in a more traditional knockout variety.

Contingent Exercise Recovery Rate Options

Another potentially very popular product will be Recovery Rate Options.These have a new event contingent exercise style similar to Europeanstyle options but with the exercise date left undefined unless anotional credit event occurs. If a relevant notional credit event occursprior to option expiry, the Recovery Rate Option resets its exercisedate and expiry date to be the same as the expiry date set for itsunderlying Recovery Rate Product and then becomes a European styleoption. If a relevant notional credit event does not occur prior tooption expiry, all options knock out in the traditional manner i.e. withloss of premium.

Recovery Rate Premium Return Options

Traders who want to use standard Recovery Rate Product Options to tradetheir view on recovery rates should a credit event occur will befrustrated by the high premium time decay that occurs as knock outapproaches i.e. if no credit event has occurred. Recovery Rate PremiumReturn Options solve this problem in a simple yet creative way by havingas their name implies a premium return feature should no credit eventoccur by expiry time. As an example consider all the buyers throughoutthe lifetime of trading of a set of one year options struck on a 3^(rd)to default Recovery Rate Product. If at expiry after the one year haspassed only two or less defaults have occurred in the referenced basketthese buyers would have all their premium returned. Obviously theseRecovery Rate Premium Return Options would have to be listed and tradedin premium paid format. A further encouragement to trade would be if thepremium paid attracted interest or could be posted with the clearinghouse through over collateralising with T-bills as is often done todaywith initial margin.

A Note on Other Event Driven Products

Credit event protection products can be viewed as just a another form ofinsurance. Other insurance products such as those that payout in theevent of loss of life, accident etc rather than in the event of adefault can therefore be generated using similar design principles. Wetherefore define a Post Event Contract to be any contract that isassigned to holders of another contract according to an objectivetriggering event. We also define Premium Return Knock Out Options as thegeneralized form of Recovery Rate Premium Return Options.

A Note on Initial Margin Calculations for the Adapted for Exchange NewCredit Derivatives Invention

Consider first an isolated single name Credit Coupon Product. Unless itis the effective Credit Coupon Product no Event Protection Futures canbe assigned against the position so margining can simply be based on astatistical analysis of historical price movements as with existingexchange traded futures. However short positions in the effective CreditCoupon Product will require very large initial margin known as a spotmonth charge to cover for the large adverse variation margin call thatmight result if a Notional Credit Event in the reference name isannounced. Since the member earns interest on initial margin held at theclearing house the short position holder is holding something closelyakin to an on exchange credit-linked note. Construction of a genuinecredit-linked note is discussed in the details of the clearing housesecurities part of the invention section below.

Now consider multiple short positions in effective Credit CouponProducts covering divers single names. Clearly the percentage initialmargin requirements should plummet for even a small portfolio in fullproportion to the low probability associated with two or more distinctNotional Credit Events in the relevant referenced names being announcedon the same day i.e. as diversification kicks in.

In the example of Traded Credit Products on an equally weighted 125 nameindex the short position initial margin spot month charge is likely tobe similar to the 0.8% weighting of each name in the index.

Clearly to deliver full benefit from the Adapted For Exchange New CreditDerivatives invention the exchange's clearing house will need to becomesufficiently sophisticated at understanding diversification withinportfolios of these products for cross margining purposes.

The Details of the Adapted for Exchange New Interest Rate SwapsInvention Overview

The Adapted For Exchange New Interest Rate Swaps invention does notrequire any Event Protection Products and Processes and so isfundamentally less complex than the Adapted For Exchange New CreditDerivatives invention. It does however involve two distinct back officeproduct types and in this sense is more complex.

Advantages

The ISDA based interest rate swap markets have been established farlonger than the ISDA based credit derivative market. The former are thuscorrespondingly far more efficient than the latter. The inventionnonetheless brings the significant benefits in the fields of:

-   Counterparty credit risk—The invention will effectively remove the    need for counterparty credit lines via central clearing of the    ISDA-like exchange traded products. It will therefore eliminate a    costly and complicated part of the trading and risk management    process and broaden access to these markets still further. This will    find particular applicability in emerging market economies where    counterparty credit issues are generally speaking far more    significant than in the developed world. Indeed the invention will    make the creation of benchmark rates for burgeoning corporate debt    markets in such countries possible without the need for significant    and costly government bond issuance.-   Netting—The invention is particularly efficient in netting    exposures. This is because of both the breakdown into coupons and    more significantly the separation of the fixed and floating    exposures into separate products.-   Daily settlements and straight through processing—A significant    uptake of the invention will result in slashed back office and    middle office costs.-   Position and risk management—Perhaps the most striking feature of    the invention is the simplifications the design brings to position    and risk management with an entire 50 year curve covered in the    preferred embodiment by as few as 400 separate Coupon Products. Even    if the current ISDA market convention of quoting on-the-run spot    plus one year, spot plus two years, etc. with a new on-the-run spot    curve every trading day the Adapted For Exchange New Interest Rate    Swaps invention design still ensures that individual trade ticket    history does not dominate position accounting so that both within a    large client portfolio and at the clearing house itself netting and    margining will take place very efficiently

The implications of a significant uptake of the invention for financialmarket stability are clearly great indeed.

Par IRS Product

The Standard Par IRS Product is the preferred embodiment of the AdaptedFor Exchange New Interest Rate Swaps invention. It does not utilise thefull potential mapping points available in the generic ISDA-likeinvention design (see FIG. 8) there being no distinction between thefront office and internal matching product:

-   The front office product is called the Traded Swap Rate (TSR) that    appears on trading and information systems is expressed in    annualised percentage points according to market convention. The    quotation convention here is the one most suitable for showing this    product's relationship to the yields in the long term debt markets.-   There are two distinct back office product types formed by the    splitting of the front office Traded Swap Rate into so called Fixed    Coupon Products (XCPs) and Floating Coupon Products (FCPs) for    booking at the clearing house etc. The combination of Fixed and    Floating Coupon Products are particularly suitable for making sure    trades within a large client portfolio are netted and margined    efficiently.

On exchange options of the above (a.k.a. Standard Par IR Swaptions) areincluded in the preferred embodiment of the Adapted For Exchange NewInterest Rate Swaps invention.

Constituent Products Design Overview

The Traded Swap Rates as quoted in the front office represent the onexchange equivalent of ISDA based interest rate swaps (IRSs). IRS ratesvary with the term of the obligation and are simply the market price fora zero cost exchange of interest rate exposure from fixed to floating orvice versa. More specifically IRS deals commit traders to enter into a)a periodic obligation to receive (or pay) a fixed interest rate inexchange; in exchange for b) a periodic obligation to pay (or receive)amounts based on a floating interest rate index (e.g. 3 month BBALIBOR), where all the interest rate amounts payable are calculated basedon the notional size of the deal.

As with other exchange traded contracts the Traded Swap Rate in itspreferred embodiment will have a standard notional unit of trading (e.g.$ 1 mln,

1 mln, ¥100 mln etc).

In the Standard Par IRS Product the Traded Swap Rates obey a listing andexpiry cycle modelled on the Traded Credit Product cycle of the AdaptedFor Exchange New Credit Derivatives invention. The appropriate length ofthe listing cycle will mirror the demand from dealers in eachcurrencies. Thus major currencies such as $,

or ¥ may have thirty to fifty years of Traded Swap Rates available fortrading whilst emerging markets may not have products listed beyondthree to five year terms. The standard listing cycle will also mirrorthe Traded Credit Product cycle with March and September expiries plusone additional quarterly month so the nearest three expiry months areconsecutive quarterly expiries. The Standard Par IRS Product expirieswill be x business days prior to the effective date which is defined asthe twentieth calendar day of the expiry month or if such a day is not abusiness day on the next following business day. The x business daysdepends in principle on the currency in question but is typically 2 days(e.g. in $,

, ¥etc).

Both the Fixed and Floating Coupon Products follow the same expiry cycleas the Traded Swap Rates obey but include all consecutive quarterlyexpiries i.e. March, June, September and December and not just March andSeptember plus one additional quarterly month expiry at the front of thecurve. Each Coupon Product has a notional maturity that is the effectivedate of the following Coupon Product expiry.

The standard notional unit size of the Floating Coupon Products will bethe same as the notional unit of trading for Traded Swap Rates (e.g. $1mln,

1 mln, ¥100 mln etc). However the standard notional unit size of theFixed Coupon Products will be the smallest unit size of the currencyi.e. only $0.01,

0.01, ¥1 etc.

Non-Standardised Dates and Spot

Towards the front of the curve there may be demand for non-standardiseddates and it is envisaged that this could be accommodated by listingthese non-standard expiries only for OTC-style telephone trading withaccess to clearing via a wholesale trading facility.

At present the current ISDA market trades spot plus one year, spot plustwo years, etc. It may be necessary in order to meet demand to list anew spot curve every trading day as well as the standard expiry cycledescribed above.

It may happen that there is also a demand for trading in non-standardnotional units and this can be accommodated simply by shrinking thenotional unit sizes until the Trade Swap Rate notional unit of tradingreaches the appropriate granularity.

Implied Calendar Spread Pricing and the Outright Traded Swap Rate

Traded Swap Rate forwards cannot easily be traded along the interestrate term structure in a manner analogous to the Adapted For ExchangeNew Credit Derivatives invention. However, one embodiment of theinvention would separately list certain forward Traded Swap Rate curveson the matching engine in order to encourage relative value tradingagainst normal calendar spreads of the outright Traded Swap Rate curve.These calendar spreads together with butterfly spreads etc will beavailable just as they are in existing standardised Short Term InterestRate futures markets provided the matching engine supports them.

Traded Swap Rate, Fixed Coupon Products, Floating Coupon Products andAssociated Mappings

The mappings that are part of the Standard Par IRS Product link thefront office Traded Swap Rate with the back office Fixed and FloatingCoupon Products directly. We now give a detailed description of thesewith reference to FIG. 8 where each mapping exists between the boundaryof the sub-products at points indicated by circles numbered 1-5. In thiscase circles 1 and 2 can be ignored as no mappings take place there forthe Adapted For Exchange New Interest Rate Swaps invention.

Mapping 3

Mapping 3 occurs at the numbered circle point 3 in FIG. 8.

FIG. 17 shows the details of the one to many mapping which converts fromthe Traded Swap Rate Fill Element (TSRFE_(m)) (see 1700 of FIG. 17) intothe relevant back office Floating Coupon Products (FCP_(i)) (shown as aset spanned by 1708 and 1710 in FIG. 17) on the one hand and theoffsetting positions in back office Fixed Coupon Products (XCP_(i))(shown as a set spanned by 1712 and 1714 in FIG. 17) on the other.

The Floating Coupon Product positions (FCP_(i)) are assigned withopposite long/short sign as the Traded Swap Rate but in exactly the samelot volume for all quarterly expiries i up to and including m (see 1702of FIG. 17):All i=1 to m,FCP_(i) Lot volume=TSRFE_(m) Lot volumeAll i=1 to m, FCP_(i)Price=0IF TSRFE_(m)=Buy THEN All FCP_(i)=Sell, ELSEIF TSRFE_(m)=Sell THEN All FCP_(i)=Buy

The Fixed Coupon Product positions (XCP_(i)) are assigned with the samelong/short sign as the Traded Swap Rate but in proportion to lot volumeand traded price for all quarterly expiries i up to and including m (see1704 of FIG. 17):All i=1 to m, XCP _(i) Lot volume=TSRFE _(m) Lot volume*A _(i) *TSRFE_(m) Price %*Traded Swap Rate notional sizeAll i=1 to m, XCP_(i) Price=0IF TSRFE_(m)=Buy THEN All XCP_(i)=Buy, ELSEIF TSRFE_(m)=Sell THEN All XCP_(i)=Sell

The accrual factor, A_(i), are simply the fraction of a year that thenumber of days between the i^(th) effective date and the i^(th) notionalmaturity date represent. The accrual factor calculation method will varywith currency and will probably be specified in the particular Par IRSProduct design. The calculation will often be made consistent with theconventional quotation method in any existing ISDA based swap markets inthat currency. Thus for a $ or e product for example the A's would bedefined in day fractions of a 30/360 day count basis. The mappingstherefore have to be parameterised by the expiry calendar for product sothat a full strip of both types of Coupon Product are assigned (see 1706of FIG. 17).

Mapping 4

Mapping 4 occurs at the numbered circle point 4 in FIG. 8. This isidentical to the mapping at numbered circle point 3 as described aboveand in FIG. 17. It is used to convert wholesale trades agreed over thetelephone into the back office representation directly.

Mapping 5

Mapping 5 occurs at the numbered circle point 5 in FIG. 8.

FIG. 18 shows the details of the conversion of the front office TradedSwap Rate Reference Prices (see 1800 of FIG. 18) as set by the marketsupervisor into the actual back office back office Floating CouponProduct (shown as a set spanned by 1814 and 1816 in FIG. 18) and FixedCoupon Product daily settlement prices (shown as a set spanned by 1818and 1820 in FIG. 18) needed for variation margin calls. This is arelatively complex process which also requires a daily stub ratereference price (see 1804 of FIG. 18) and is key to the product designas a Par IRS Product.

The Traded Swap Rate Reference Prices do not in principle need torespect the Traded Swap Rate Tick and may be calculated from someobjective averaging function of trading conditions just prior to thedaily settlement time.

Module 1804 of FIG. 18 illustrates the bootstrapping process used tocalculate the required discount factors. The first step in module 1804of FIG. 18 is to use interpolation to determine Traded Swap Ratesettlements in time periods for which an express rate does not existi.e. at the June and December points. Linear interpolation, exponentialinterpolation, cubic spline interpolation, exponential splineinterpolation, or any other desired type of interpolation may be used.The result is that a Traded Swap Rate Reference Price is available forevery Fixed Coupon Product and Floating Coupon Product effective date i.By definition of the product design the Traded Swap Rate ReferencePrices form a par swap curve.

In the next step of module 1804 of FIG. 18 we calculate two series offorward zero coupon discount factors. The first series, d_(i), are fromthe first effective date to every notional maturity date i. The secondseries, f_(i), are from every effective date i to the correspondingnotional maturity date i. The discount factor d_(i) represents the zerocoupon discount factor calculated from the par swap rate applicable forthe period between the first effective date and the i^(th) notionalmaturity date. For time period i=1, the following formula is used todetermine d₁: $d_{1} = {f_{1} = \frac{1}{1 + {A_{1}C_{1}}}}$where A₁ and C₁ are the accrual factor and the swap rate, respectively,for the first time period (i=1).

For all time periods from i=2 to i=m, bootstrapping is applied, usingthe following formula to determine d_(i):$d_{i} = \frac{1 - {C_{i}{\sum\limits_{j = 1}^{i - 1}{A_{j}d_{j}}}}}{1 + {A_{i}C_{i}}}$where j is a positive integer, and A_(i) and A_(j) are the accrualfactors in time period i and j, respectively. This process is commonlyknown as bootstrapping because d_(i−1) has to be determined in order todetermine d_(i) just as boot and skate laces need to be tightened fromthe bottom before they can be tightened at the top.

The f_(i) can then be determined directly from the d_(i) as follows:$f_{\quad i} = \frac{\mathbb{d}_{i}}{{\mathbb{d}i} - 1}$

We also need the stub discount factor D₀ which is the zero coupondiscount factor calculated from the money market stub reference rateapplicable for the period between trade date plus x business days(typically 2 days) and the first effective date (see 1806 of FIG. 18):$D_{0} = \frac{1}{1 + {a_{0}S_{0}}}$where a₀ and S₀ are the money market accrual factor and the stub rate,respectively, for the period from spot to the first effective date.Preferably, the stub rate source is a identical to the floating rateused in the swap market (e.g. the BBA $ LIBOR panel for $ Traded SwapRates). The accrual factor a₀ is calculated using the daycount basisconventional in the relevant money market e.g. Actual/360 for a $ or

product. The mappings therefore have to be parameterised by the expirycalendar for product so that a full strip of both types of CouponProduct are assigned (see 1808 of FIG. 18).

We may now finally give the formulae for the Floating Coupon Product,FCP_(i), and Fixed Coupon Product, XCP_(i), daily settlement pricesneeded for variation margin calls:${FCP}_{i} = {\left( {\frac{1}{f_{i}} - 1} \right)*d_{i}*D_{0}}$XCP_(i) = d_(i) * D₀respectively shown in modules 1810 and 1812 of FIG. 18.

Expiry of Fixed and Floating Coupon Products

Fixed and Floating Coupon Products are cash settled at expiry (see FIG.5). The settlement uses a standard floating rate benchmark, L, thatvaries according to currency e.g. the $ Traded Swap Rates will use 3month BBA $ LIBOR.

The Floating Coupon Product is cash settled using the formula (see 506of FIG. 5): ${{FCP}\quad{EDSP}} = \frac{a*L}{1 + {a*L}}$where a is the relevant money market convention accrual factor.

The Fixed Coupon Product is cash settled using the formula (see 506 ofFIG. 5): ${{XCP}\quad{EDSP}} = \frac{1}{1 + {a*L}}$where a is the relevant money market basis accrual factor.

A Note on Margin Calculations for the Adapted for Exchange New InterestRate Swaps Invention Granularity

The very small notional unit size of the Fixed Coupon Products posessome technical issues to do with rounding error in both the calculationsof daily settlement price and indeed EDSPs. If rounding errors are notaddressed the invention will deliver random variations from a true parswap. It is therefore a requirement of the invention that variationmargin calls are calculated for each position holder using Fixed CouponProduct DSPs and EDSPs of high accuracy i.e. not rounded to the nearestcent, pence, yen etc. Only after the relevant mark to market has beencalculated in this way should total position variation margin calls becalculated with rounding.

In the circumstances described above there is however a possibility thatthe clearing house will end up with a small shortfall of variationmargin cashflows. Three solutions present themselves:

-   -   1. Ignore the issue as even in the case of many thousand        position holders the mismatch of cashflows is likely to be        exceedingly small and insignificant relative to initial margin        held; and/or    -   2. Reduce and for practical purposes eliminate the risk of a        shortfall when final cash settlement margin calls are calculated        by rounding the EDSP differently for net long and net short        positions i.e. in the clearing house's favour; or    -   3. Handle rounding errors in detail via the front office        position markers held in the clearing house's trade registration        systems (see Reconciliation, efficient give ups and open        interest markers).

Which of these options is adopted depends on the commercialconsiderations of customers and the clearing house.

Give Ups

As the preferred embodiment of the invention has both Fixed and FloatingCoupon Products created at zero price and in offsetting pairs there willbe a one-off pair of large but offsetting variation margin callscalculated for each different type of coupon upon their first dailysettlement. It is therefore important to keep the coupon productstogether prior to this point and not allow them to be allocated todifferent accounts (see Reconciliation, efficient give ups and openinterest markers).

Second Generation Deliverable Bond-Like Futures Overview

The Adapted For Exchange New Interest Rate Swaps invention and theAdapted For Exchange New Credit Derivatives invention can be used tocreate deliverable bond-like futures. These would therefore be secondgeneration products very much in the mould of traditional bond futuresbut that give robust exposure to the two aforementioned inventiveproducts in a convenient form.

Advantages

This second generation deliverable bond-like futures invention bringssignificant practical benefits:

-   -   Convenience of trading—As already explained in the event that        the market prefers the current ISDA market spot plus one year,        spot plus two years, etc format for listings it would be        necessary to list a new spot IRS product curve every trading day        every day. Rather than in addition to this listing the        standardised Par IRS Product on a March, June, September,        December expiry cycle as described previously, it may be more        convenient to list 2-year, 5-year and 10-year deliverable swap        future as described below.    -   Convenience of hedging—Listing a complex of 2-year, 5-year and        10-year deliverable credit-linked futures as described below        will create a very convenient hedge for non government (i.e.        risky) bond positions.    -   Appropriate fee structure—The exchange listing more traditional        2-year, 5-year and 10-year deliverable bond-like futures will be        able to charge an appropriate bond future-like fee. The low fee        will allow the very cost sensitive independent scalpers (i.e.        office based locals) to participate in providing liquidity as        effectively as they do for existing bond futures. Meanwhile        those who want continuing exposure to the actual Adapted For        Exchange New Interest Rate Swaps and the Adapted For Exchange        New Credit Derivatives products can do so at a higher fee        appropriate to the long term nature of these derivatives.

Deliverable Swap Futures

We have already described in the “Background to the Invention” sectionhow the M-year CBoT Swap future design has a cash settlement upon expiryformula:${{CBoT}\quad{Swap}\quad{Future}\quad{EDSP}} = {\frac{C}{S} + {\left( {1 - \frac{C}{S}} \right)*\left( {1 + \frac{S\quad\%}{2}} \right)^{\frac{1}{2*M}}}}$where,

-   -   S represents the ISDA Benchmark Rate for the M-year U.S. dollar        interest rate swap on the last day of trading, expressed in        percent terms; and    -   C represents the notional coupon for the future, expressed in        percent terms (currently C=6 for both the 5-year and 10-year        Swap futures that are listed)

An alternative approach would be to reverse the above formula and createa deliverable design. This would set the EDSP by reference the marketclose of the swap future on the last trading day in the same way thatbond futures are expired. Once the EDSP is known the EDSP Swap Rate, S,is calculated. Finally delivery is made via the Adapted For Exchange NewInterest Rate Swaps invention. Specifically the delivery counterpartiesare assigned by the normal bond future method. Then a front office tradein the Traded Swap Rate is delivered with traded price set to the EDSPSwap Rate, S, adjusted as necessary for coupon and compoundingconsistency.

Deliverable Credit-Linked Futures

In exact analogy to the deliverable swap futures just described otherfutures could be listed linked to credit indices such as the Dow JonesCDX North America and iTraxx Europe or even sector indices.

These would set the EDSP by reference the market close of the relevantfuture on the last trading day in the same way that the correspondingswap futures was expired and crucially do so at the same time. Once theEDSP is known the EDSP Credit-linked Rate, R=S+P, is calculated in thesame way. Finally delivery is made via the Adapted For Exchange NewInterest Rate Swaps and the Adapted For Exchange New Credit Derivativesinventions. Specifically the delivery counterparties are assigned by thenormal bond future method. Then a front office trade in the Traded SwapRate is delivered with traded price set to the EDSP Swap Rate, S. Inaddition a front office trade in the relevant Traded Spread Product isdelivered with traded price set to the EDSP Credit-linked Rate minus theEDSP Swap Rate, R−S=P. There may be better more sophisticated ways tocalculate, P, but the principle will be the same.

One problem for deliverable credit linked futures is how to deal with arelevant notional credit event prior to expiry, and perhaps the bestsolution for a single name product is simply to suspend trading in thelinked future and force an early expiry and delivery based on its mostrecent daily settlement price. The problem is more complex formulti-name products such as indices and baskets and perhaps the bestsolution here is to avoid the problem by construction=13 The problemwould not arise these credit linked futures reference either a resettingindex or a newly composed index at its expiry.

The Details of the Adapted for Exchange New Money Market DerivativesInvention Overview

The Adapted For Exchange New Money Market Derivatives invention as bothOIS and/or FRA Product are similar in complexity to the Adapted ForExchange New Interest Rate Swaps invention. On the one hand theseproducts have a single expiry and do not need the breakdown into coupontype products. On the other hand the introduction of the money marketconvention and non-standard notional units of trading add considerablecomplexity.

Advantages

The ISDA based money market derivatives have been established far longerthan the ISDA based credit derivative market. The former are thuscorrespondingly far more efficient than the latter. The inventionnonetheless brings significant benefits in the fields of:

-   Counterparty credit risk—The invention will effectively remove the    need for counterparty credit lines via central clearing of the    ISDA-like exchange traded products. It will therefore eliminate a    costly and complicated part of the trading and risk management    process and broaden access to these markets still further. This will    find particular applicability in emerging market economies where    counterparty credit issues are generally speaking far more    significant than in the developed world.-   Forwards and spot—The invention is particularly effective in meeting    end user needs. Whereas the existing standardised Short Term    Interest Rate futures markets are professional forward-forward    markets with esoteric expiry dates unrelated to business needs, the    invention makes forward and spot money market derivatives available    within a genuine exchange for the first time.-   OTC-style trading—By virtue of the product designs continuously    quoted central markets will only be available on the exchange at    money market conventional on-the-run points. Block trades and basis    trades thresholds will therefore be zero for off-the-run points    allowing them to be freely traded in an OTC-style phone market yet    still benefit from the exchange's infrastructure.-   Daily settlements and straight through processing —A significant    uptake of the invention will result in slashed back office and    middle office costs.-   Position and risk management—Both leg types of the OIS Product are    designed to make sure trade ticket history does not dominate    position accounting so that both within a large client portfolio and    at the clearing house itself netting and margining will take place    very efficiently.

Listing Convention and Units of Trading Implied Pricing and the MoneyMarket Convention

Both OIS and FRA Product varieties of the Adapted For Exchange New MoneyMarket Derivatives invention use the money market convention that hasalready been described in the “Background to the invention” section.Thus each trading day a restricted subset of on-the-run points will bemade available for trading on the matching engine even though the fullset will remain available for trading via OTC-style wholesale tradingfacilities. This will require:

-   daily listing and delisting of product for matching engine trading;    and-   daily adjustments to block trade thresholds for listed and delisted    product.

The latter point is required so that traders can if they wish tradewhere no matching engine listing exists i.e. the block trade thresholdmust be zero for off-the-run points.

Non-Standard Notional Units of Trading and Rounding Issues

When managing short term exposures the exact notional sizes requiredtend to be known with greater accuracy. It is therefore appropriate toallow greater flexibility in the notional units of trading in theAdapted For Exchange New Money Market Derivative invention than for theother longer dated ISDA-like derivative products.

The preferred embodiment of this Adapted For Exchange New Money MarketDerivatives invention for both OIS and FRA Product would therefore allownotional front office trading lot size to be to the smallest unit sizeof the currency i.e. only $0.01,

0.01, ¥1 etc. The very small notional unit size of the traded productmight in principle raise fears of some technical issues to do withrounding error. However as with the Adapted For Exchange New InterestRate Swaps Invention this is not ultimately a problem as long as allpositions and variation margin calls are calculated to high accuracy(i.e. not rounded to the nearest cent, pence, yen etc). This isespecially true of back-office products who's notional size is afunction of on screen traded price and not just front office volume.

Only after the relevant mark to market has been calculated to highaccuracy should total position variation margin calls be calculated withrounding per product. Specifically when margin calls or final cashsettlement are calculated the rounding should be done differently fornet long and net short positions i.e. in the clearing house's favour.

OIS Product

The OIS Product is one embodiment of the Adapted For Exchange New MoneyMarket Derivatives invention. It does not utilise the full potentialmapping points available in the generic ISDA-like invention design (seeFIG. 8 ) there being no distinction between the front office andinternal matching product:

-   The front office product is called the Traded OIS Rate (TOR) that    appears on trading and information systems is expressed in    annualised percentage points according to market convention. The    quotation convention here is the one most suitable for showing this    product's relationship to rates in the cash money markets. The    Traded OIS Rate is also important for audit trail purposes.-   There are two distinct back office product types formed by the    splitting of the front office Traded OIS Rate into a so called Fixed    Rate OIS Product (FROP) and an Overnight Indexed Product (OIP) for    booking at the clearing house etc. Both the Fixed Rate OIS and the    Overnight Indexed Products are designed to make sure trade ticket    history does not dominate position accounting so that within a large    client portfolio netting and margining takes place efficiently.

On exchange options of the above (a.k.a. OI Swaptions) are included inthe preferred embodiment of the Adapted For Exchange New Money MarketDerivatives invention.

Traded OIS Rate, Fixed Rate OIS Product, Overnight Indexed Product andAssociated Mappings etc

The mappings that are part of the OIS Product link the front officeTraded OIS Rate with the back office Fixed Rate OIS and OvernightIndexed Products directly. We now give a detailed description of thesewith reference to FIG. 8 where each mapping exists between the boundaryof the sub-products at points indicated by circles numbered 1-5. In thiscase circles 1 and 2 can be ignored as no mappings take place there forthe Adapted For Exchange New Money Market Derivatives invention.

Mapping 3

Mapping 3 occurs at the numbered circle point 3 in FIG. 8.

FIG. 19 shows the details of this one goes to two mapping that convertsfrom the Traded OIS Rate Fill Element (TORFE) (see 1900 of FIG. 19) intothe relevant back office Overnight Indexed Product (OIP) (see 1902 ofFIG. 19) and offsetting back office Fixed Rate OIS Product (FROP) (see1904 of FIG. 19).

The Overnight Indexed Product (OIP) position is assigned with theopposite long/short sign as the Traded OIS Rate but in exactly the samelot volume and for exactly the same expiry (see 1902 of FIG. 19):OIP Lot volume=TORFE Lot volumeOIP Price=0IF TORFE=Buy THEN OIP=Sell, ELSEIF TORFE=Sell THEN OIP=Buy

The Fixed Rate OIS Product (FROP) position is assigned with the samelong/short sign as the Traded OIS Rate both in proportion to lot volumeand also as a function of actual matched Traded OIS Rate price asde-annualised for the appropriate expiry (see 1904 of FIG. 19):FROP Lot volume=TORFE Lot volume*(100%+a*TORFE Price %)FROP Price=0IF TORFE=Buy THEN FROP=Buy, ELSEIF TORFE=Sell THEN FROP=Sell

The accrual factor, a, is simply the fraction of a year that the numberof days between the spot date (T+x, where x is most typically 2 businessdays) and the expiry date represent. The accrual factor calculationmethod will vary with currency and will be specified in the particularOIS Product design. The calculation will usually be made consistent withthe conventional quotation method in the existing ISDA based OIS marketsin that currency. Thus for a $ or

product for example the a's would be defined in day fractions of anActual/360 day count, spot=T+2 basis. This mapping therefore has to beparameterised by the expiry calendar for product so that this accrualfactor can be calculated (see 1906 of FIG. 19).

Mapping 4

Mapping 4 occurs at the numbered circle point 4 in FIG. 8. This isidentical to the mapping at numbered circle point 3 as described aboveand in FIG. 19. It is used to convert wholesale trades agreed over thetelephone into the back office representation directly.

Mapping 5

Mapping 5 occurs at the numbered circle point 5 in FIG. 8.

FIG. 20 shows amongst other things the details of the mapping thatconverts the front office Traded OIS Rate Reference Prices (see 2002 ofFIG. 20) as set by the market supervisor into the actual back officeback office Fixed Rate OIS Product (see 2010 of FIG. 20)and OvernightIndexed Product (see 2008 of FIG. 20) daily settlement prices needed forvariation margin calls.

The Traded OIS Rate Reference Prices do not in principle need to respectthe Traded OIS Rate tick and may be calculated from some objectiveaveraging function of trading conditions just prior to the dailysettlement time.

Module see 2006 of FIG. 20 illustrates the two steps needed to calculatethe discount factors required to settle the Fixed Rate OIS Product. Thefirst step is to use interpolation to determine Traded OIS Ratesettlements in time periods for which an express rate does not existi.e. at off-the-run points. Exponential interpolation, cubic splineinterpolation, exponential spline interpolation, or any other desiredtype of interpolation may be used. The result is that a Traded OIS RateReference Price, O_(i), is available for every possible expiry date i.

In the next step we calculate zero coupon discount factors, d_(i),calculated from Traded OIS Rates, O_(i), for the period between the spotdate and the relevant expiry date. The following formula is used:$d_{i} = \frac{1}{1 + {a_{i}O_{i}}}$where the a_(i) are the accrual factor for the relevant period. For theperiod up to the spot date we set the d's=100%. This mapping thereforehas to be parameterised by the expiry calendar for product so that thisaccrual factor can be calculated (see 2004 of FIG. 20).

The formulae for the daily settlement prices needed for variation margincalls for the Overnight Indexed Product, OIP_(i), and Fixed Rate OISProduct, FROP_(i), are thus:OIP_(i)=100%FROP_(i)=d_(i)as indicated in modules 2008 and 2010 of FIG. 20 respectively.

Overnight Indexation

Module 2008 of FIG. 20 also shows the process required for indexation toa daily overnight index rate, X, such as the Fed Funds rate. It is keyto the product design as a true OIS Product. Although the dailysettlement prices of the Overnight Indexed Products, OIP_(i), remain100% for the entire life of a position, each evening the position sizeis augmented as follows:For all j=1 to m, non-compounding positions, OIP1_(j), less than x daysold: New OIP1_(j) position=Old OIP1_(j) positionFor all i=1 to m, compounding positions, OIP2_(i), x or more days old:New OIP2_(i) position=Old OIP2_(i) position*(100%+A _(O/N) *X%)i.e. Addition OIP2_(i) volume=Old OIP2_(i) position*A _(O/N) *X%and Addition OIP2_(i) price=0where A_(O/N) is the accrual factor applied to the overnight index rate,X, is (in $'s usually a 1/360 or a 3/360 for a Friday etc). Also x isthe number of business days defining spot (T+x) for this currency(usually x=2). Notice that the accuracy to which the Overnight IndexedProduct position will be held is higher than the smallest unit size ofthe currency i.e. only $0.01,

0.01, ¥1 etc. even though this is the notional trading lot size. Thisprocess therefore requires the calendar so that the overnight accrualfactors can be calculated (see 2004 of FIG. 20).

Position Keeping Efficiency

We have stated without explanation that both position and risk will bemore efficiently managed in the current design than in the existingISDA-style one.

As previously explained the on-the-run market exists at maturities of awhole number of weeks, months or years i.e. spot plus 1 week, spot plus2 weeks, spot plus 3 weeks, spot plus 1 months, spot plus 2 months, spotplus 3 months, spot plus 4 months, spot plus 5 months, spot plus 6months, spot plus 7 months, spot plus 8 months, spot plus 9 months, spotplus 10 months, spot plus 11 months, spot plus 1 year etc. In all thismakes 15 or more different classes of trade ticket. For each givenexpiration day there are therefore an increasing density of differentclasses expiring with reducing time to expiry each of which have to bevalued separately. Furthermore the lack of unbundling of the legs willfurther multiply the position and risk management overhead and ticketmanagement burden.

By contrast there is only one Fixed Rate OIS Product (FROP) for eachexpiry and one compounding Overnight Indexed Product (OIP2) for eachexpiry plus ˜15 times x non-compounding Overnight Indexed Product (OIP2)for newer positions where x is the number of business days definingspot.

Give Ups

As the preferred embodiment of the invention has both Fixed Rate OISProduct and Overnight Indexed Product created at zero price and inoffsetting pairs there will be a one-off pair of large but offsettingvariation margin calls calculated for each different leg type upon theirfirst daily settlement. It is therefore important to keep the twoproduct types together prior to this point and hence restrict give ups(see Reconciliation, efficient give ups and open interest markers).

Expiry of Fixed and Overnight Indexed Products

Fixed Rate OIS and Overnight Indexed Products are both cash settled to100% at expiry (see 506 of FIG. 5).

FRA Product

The FRA Product is extremely closely related to the Par IRS Product (seepage 75). In fact the FRA product is identical to the front quarterlyPar IRS Product which breaks down into a single pair of back-officeproducts (i.e. no strip) except that:

-   -   The equivalent of the Traded Swap Rate known as the Traded FRA        Rate will be quoted using the money market day count convention        and not the swap market convention.    -   FRA Products are not restricted to quarterly terms.    -   As with the OIS Product daily listing and delisting of product        for matching engine trading of on-the-run points will occur.

In practice only three month and six month terms will need to be listedas these are the most liquid in the ISDA based market. Thus on any givenday 1×4 (=one month forward for three months), 2×5, 3×6, 4×7, 5×8 and6×9 will be listed amongst the three month FRA Products and 1×7, 2×8,3×9, 4×10, 5×11 and 6×12 will be listed amongst the six month FRAProducts. Hence six different stub rates will be needed.

To prevent duplication we won't recast the discussion of the Par IRSProduct here for the sake of the FRA product which is identical to it.

Introduction to the Enhanced Clearing House Flexibility InventionDescription and Novelty of this Part of the Invention

Some clearing house changes have already been discussed as part of theISDA-like invention above. However the Enhanced Clearing House inventiontakes the standard futures exchange's clearing house and with a fewminor changes transforms it into something far broader i.e. a) a centralcash money market; or b) a securitisation of loans venue; or indeed c) arival to existing securities depositories; and in particular d) a rivalissuance venue for securities normally issued by special purposevehicles.

The extent to which some of these innovations are attractive to themarket remains to be seen. However to broaden the role of thetraditional futures and options exchange trading and clearing venue inorder to streamline the operations of the financial industry is entirelyconsistent with the preceding ISDA-like product part of invention. Thefirst part of the invention sought to replace ISDA's coordinating rolewith a truly central market in the main derivative products traded bythe market. This part of the invention concerns the well-worn yetuntested assumption that operational risk can best be managed bycoordination of piecemeal projects distributed across the industry. Theharnessing of existing efficiencies within futures exchanges and theclearing house's in a broader context to create a truly central providerof operational services across the industry challenges orthodoxy. It isthis contrasting approach that is presented here and not surprisingly itis linked to the first part of the invention in several places.

The Details of the Clearing House System Innovations Already Needed forthe First Part of the Invention Order of Margining Calculations andRounding

The small notional units of trading in the invention require that margincalls and position sizes are calculated with high accuracy i.e. notrounded to the nearest cent, pence, yen etc. during intermediate steps.Only after the relevant mark to market and positions have beencalculated to high accuracy in this way should total position margincalls be calculated with rounding.

Reconciliation, Efficient Give Ups and Open Interest Markers

As already stated since the product designs of the first part of theinvention lead to each individual front office trade being split intotwo or more back office positions this will require system changes forefficient post trade management. Thus the preferred embodiment of theinvention will conserve information appropriately and allow forefficient manipulation of it:

-   -   All front office product fill reports on a dealer's trading        system will be accompanied by the relevant back office product        breakdowns to help with front office versus back office        reconciliation.    -   All front office product matched trades will be passed through        to the clearing house. These filled front office trades will        appear on the clearing house's trade register as normal        contracts but will not be charged any initial or variation        margin.    -   Front office position markers held at the clearing house can be        used to assist with front office versus back office        reconciliation. They will also be used for calculating open        interest reports for front office systems.    -   Front office position markers held at the clearing house will        also be used for efficient give ups. The preferred embodiment of        the invention will allow back office managers to give up and        take in products by reference to the front office position        markers held in the clearing house's trade registration systems        alone. The associated back office products referenced to a        particular front office trade would be transferred as a group        that moves wherever their front office position marker goes.

The Delivery of Loans into the Recovery Auction or Rate Product

The delivery of loans into the Recovery Auction or Rate Product of theAdapted For Exchange New Credit Derivatives may be deemed essential bythe market. How this can be achieved is discussed separately in thedetails of the clearing house securities part of the invention sectionbelow.

The Details of the Internal Fungibility Invention Overview

A modern futures and options exchange is a highly efficient primarymarket in a certain subset of derivatives contracts. However even thesemodern electronic exchanges must have predefined trading hours and timeswhen the market is closed. This contrasts with the flexibility of theOTC ISDA based market which trades on demand at any time globally.

Electronic linkages with foreign exchanges have been attempted to solvethis problem. The lead example is the CME/SIMEX MOS link but othersimilar linkages followed. However this approach has hit some genuinelimitations. No single link-up can sensibly cover the entire 24-hourtrading period yet competitive considerations between differentfinancial centres makes a worldwide linkage system almost impossible toset up, with attempts to do so hit by regulatory and legalcomplications.

Given the opportunities of electronic trading to give access to the sameexchange across global time zones in recent years exchanges haveattempted to expand their trading sessions to become near 24-hour a daymarkets. The idea is to preserve local business flows and attractbusiness generated on foreign shores. However these exchanges havefailed to address the operational difficulties caused by the long daymarkets they have created.

By intelligently introducing three or more different daily settlementtimes for each near 24-hour a day market operational difficulties can befully addressed.

Advantages

This part of the invention introduces three or more different dailysettlement times for each near 24-hour a day market which has theadvantage of:

-   -   Avoiding all clearing members being forced to either a) maintain        expensive 24 hour back offices; or b) outsource part of their        back offices coverage to a costly global service provider; and    -   Allowing traders and institutions to sensibly mark to market        across product classes within each region; and    -   Avoiding many of the regional competition pitfalls that lead to        politically motivated regulatory and legal complications.

Internal Fungibility and Multiple Daily Settlement Times MembershipStructure Basic Structure

This part of the Enhanced Clearing House invention requires simple butsignificant changes that introduce:

-   -   a) Three or more different daily settlement times within the        same clearing house for each near 24-hour a day market e.g. an        Asian close, a European close and an Americas close; and    -   b) Hence three or more different daily variation margin        collection cycles; and    -   c) A clearing membership qualification by region. Any clearing        member would have to demonstrate the capacity to staff it's back        office for the relevant daily settlement and clearing cycle        before being qualified. Thus ABC Corp might be a clearing member        only for the European close for example. However XYZ bank might        be a clearing member for all time zones.    -   d) Each individual clearing house account reference will also        carry a time zone designation and all trades within that        individual clearing house account will settle in the same time        zone. Note that a clearing member cannot own account references        for regions in which it is not qualified e.g. ABC Corp cannot        own Asian close account references.    -   e) A system for monitoring variation margin mismatches over the        trading day caused by the splitting of settlement times and open        positions across regions.

The clearing house needs only to be confident that its own capital fundor credit lines will not be exhausted by variation margin mismatchesover the trading day caused by the splitting of settlement times inorder to provide such a service. With the above changes a truly globalexchange that is operationally efficient is finally possible.

Introduction to the Pooled Risk Deposit Market Invention Description andNovelty of this Part of the Invention

Bank lending has been the corner-stone of financial activity forcenturies and an active interbank market is considered vital to anymodern economy. There are however periodic crises in which a bank mayfail and the ensuing chaos takes a considerable amount of time to unwindand for the risk of contagion to pass.

There are two separate streams of effort attempting to keep thefinancial system in order:

-   -   1. Individually the banks expend a large amount of resources        setting counterparty credit exposure limits amongst themselves        which helps to control risk of contagion; and    -   2. Also regulatory authorities focus considerable resources        setting and policing capital adequacy rules and reserve        requirements to prevent bank failures in the first place.

The present invention recognises that these two streams of effort shouldbe overhauled, modernised and replaced by a single fully robust systemspringing from an adapted futures exchange type environment.

The details of the pooled risk deposit market invention

Overview

A modern futures and options exchange is a highly efficient primarymarket in a certain subset of derivatives contracts. Because of thecentral counterparty services created by the exchange's clearing housethese derivatives contracts behave almost like securities. Byintroducing immediate cash currency payments plus an alternative methodof handling default risk as compared to the current margin based systema highly operationally efficient central money deposit market can becreated.

Advantages

The object of this part of the invention is to:

-   repackage and vastly simplify counterparty credit exposures amongst    the top tier banks; and-   reduce the operational risks associated with traditional cash money    markets i.e. depos.

This is done by once again harnessing the efficiency of the electronicfutures exchange-like environment. Apart from the obvious and extensiveadvantages associated with removing the need to separately manage largefractions of the overall counterparty risk in these markets this part ofthe invention allows the efficient intervention of central banks intimes of a bank failure.

Pooled Risk Deposit Product Market Structure

This part of the Enhanced Clearing House invention requires systemchanges that introduce ‘payment versus delivery’ into primary market forthe first time. We are therefore moving away, from leveraged products tofully funded products and indeed away from derivatives towards theunderlying cash. This Pooled Deposit Product nonetheless is very similarto the previous products described though it does not utilise the fullpotential mapping points available in the modified exchange design (seeFIG. 8 ) there being no distinction between the internal matchingproduct and back office product:

-   -   The front office product is called the Traded Rate Product (TRP)        that appears on trading and information systems its price is        expressed in annualised percentage points according to the money        market day count convention. The Traded Rate Product volume is        basically the amount of money being borrowed or lent and so its        notional lot size has to be the smallest unit size of the        currency i.e. only $0.01,        0.01, ¥1 etc.    -   The internal matching product is called the Forward Value        Product (FVP) and remixes the price and volume information of        the Traded Rate Product into the most appropriate form for use        of existing exchange implied book matching technology. The        Forward Value Product price is the same as the discount factor        associated with the Traded Rate Product price and term expressed        to high accuracy. The Forward Value Product volume is basically        the amount of money being repaid at the forward date given the        Traded Rate Product price, term and volume. Thus the notional        lot size must also be the smallest unit size of the currency        i.e. only $0.01,        0.01, ¥1 etc.

All expiries going out to two years will be listed for back officepurposes.

Traded Rate Product, Forward Value Product and Associated Mappings

The mappings that are part of the Pooled Deposit Product link the frontoffice Traded Rate Product with the internal matching and back officeForward Value Product as already described in general terms above. Wenow turn to specifics and describe these with reference to FIG. 8 whereeach mapping exists between the boundary of the sub-products at pointsindicated by circles numbered 1-5. However in this case circle 3 can beignored as no mapping takes place there for the Pooled Deposit Productinvention.

Mapping 1—Inbound

Mapping 1 occurs at the numbered circle point 1 in FIG. 8.

The top half of FIG. 21 shows the details of the one to one inboundmapping that converts a dealer's front office Traded Rate Product Orders(see 2100 of FIG. 21) into an Forward Value Product Order (see 2102 ofFIG. 21) for internal matching.

Traded Rate Product orders (TROs) are mapped onto outright Forward ValueProduct order (FVOs) for internal matching as follows (see 2102 of FIG.21):FVO Lot volume=TRO Lot volume*(100%+a*TRO Price %)IF TRO=Buy THEN FVO=Sell, ELSEIF TRO=Sell THEN FVO=BuyFVO Price=100%/(100%+a*TRO Price %)

The mapping has to be parameterised by the expiry dates of the productsand the trade date (see 2104 of FIG. 21). The accrual factor, a, issimply the fraction of a year that the number of days between the spotdate (T+x) and the expiry date represent (x is usually 2 days). Theaccrual factor calculation method will vary with currency consistentwith the conventional quotation method in the existing markets. Thus fora $ or

product for example the a's would be defined in day fractions of anActual/360 day count basis.

Mapping 1—Outbound Orderbook and Fill Reporting

Mapping 1 occurs at the numbered circle point 1 in FIG. 8.

The bottom half of FIG. 21 shows the details of the one to one outboundmapping converts the Forward Value Product Order or Fill (see 2106 ofFIG. 21) as used during internal matching back to the Traded RateProduct (see 2108 of FIG. 21) in the natural reverse mapping mapping:IF FVO=Buy THEN TRO=Sell, ELSEIF FVO=Sell THEN TRO=BuyTRO Price=(100%/FVO Price %−100%)/aTRO Lot volume=FVO Lot volume /(100%+a*TRO Price %)

Where again the mapping has to be parameterised by the expiry dates ofthe products and the trade date (see 2104 of FIG. 21), with ‘a’ beingthe relevant accrual factor. It may be simpler computationally to simplystore the front office product details with the Forward Value Productorderbook or fill as used for internal matching rather than calculatethe reverse mapping.

Mapping 2

Mapping 2 occurs at the numbered circle point 2 in FIG. 8.

This is identical to the first outbound mapping at numbered circle point1 in FIG. 8 but for quote vendor screens.

Mapping 4

Mapping 4 occurs at the numbered circle point 4 in FIG. 8.

This is identical to the inbound mapping at numbered circle point 1 inFIG. 8. It is used to convert wholesale trades agreed over the telephoneinto the Forward Value Product for back office use directly.

Mapping 5

Mapping 5 occurs at the numbered circle point 5 in FIG. 8.

This is the conversion of the front office Traded Rate Productsettlement prices as set by the market supervisor into the actual backoffice Forward Value Product daily reference prices needed for mark tomarket if required. No variation margin nor initial margin calls arehowever applied to the Forward Value Product.

The Traded Rate Product settlement prices do not in principle need torespect the Traded Rate Product tick and may be calculated from someobjective averaging function of trading conditions just prior to thedaily settlement time.

The first step is to use interpolation to determine Traded Rate Productsettlements in time periods for which an express rate does not existi.e. at off-the-run points. Exponential interpolation, cubic splineinterpolation, exponential spline interpolation, or any other desiredtype of interpolation may be used. The result is that a Traded RateProduct settlement price, I_(i), is available for every possible expirydate i.

In the final step we calculate zero coupon discount factors, d_(i),which are used as the actual daily reference prices for the ForwardValue Product, FVP_(i). The discount factors are calculated from TradedRate Product settlement prices, I_(i), for the period between the spotdate and the relevant expiry date. The following formula is used:${FVP}_{i} = {d_{i} = \frac{1}{1 + {a_{i}I_{i}}}}$where the a_(i) are the accrual factor for the relevant period.

Initial Payment Versus Delivery, Forward Value Product Expiry Payments,Credit Pooling and a Potential Role for Central Banks

Whenever a Traded Rate Product trades it results in a ‘immediate’delivery from TRP shorts to TRP longs of cash currency equivalent to theTraded Rate Product lot size traded. In this case immediate means spotdated except for overnight and tom-next trades etc. Likewise when aForward Value Product position expires it results in a delivery from FVPshorts to FVP longs of cash currency equivalent to the Forward ValueProduct position size held.

Now this Pooled Deposit Product market will have rules only allowing topquality banks of highest creditworthiness to participate. For eachexchange member all payments due would be made net to the clearinghouse. Should a default occur and a cash currency payment not be madeavailable by an exchange member to the clearing house the shortfall infunds to pay-out to other members would be distributed pro rata afternetting. This is the essence of credit pooling and any trade in thisPooled Deposit Product market would therefore carry the same creditrating.

If the market's rules allow a short grace period after a default thenthe defaulting member might be able to make good the shortfall of fundsplus interest. However after a true default the culpable member would beexpelled and the clearing house would trade out of their remainingForward Value Product position as quickly and efficiently as possible.Again any loss incurred in unwinding or transferring positions would bedistributed among the other members according to principles establishedat the time of the market's founding.

One variant of this invention would reintroduce the concept of initialmargin to cover borrowing (i.e. short Forward Value Product) positions.This would then be used as a cushion against default. There is aninteresting analogy with reserve requirements here. One advantage thePooled Deposit Product market approach is that it allows the centralbank to efficiently monitor the market at normal times and intervenequickly at times of a member bank failure. Thus for example as adefaulting bank is expelled from the system instead of the clearinghouse unwinding or transferring positions to other normal members itcould in principle transfer the entire defaulting bank's position to thecentral bank.

The Money Market Convention and Implied Pricing

Pooled Deposit Product invention uses the money market convention thathas already been described in the “Background to the invention” section.Thus each trading day a restricted subset of on-the-run points will bemade available for trading on the matching engine even though the fullset will remain available for trading via OTC-style wholesale tradingfacilities. This will require:

-   -   daily listing and delisting of product for matching engine        trading; and    -   daily adjustments to block trade thresholds for listed and        delisted product.

The latter point is required so that traders can if they wish tradewhere no matching engine listing exists i.e. the block trade thresholdmust be zero for off-the-run points.

Ratio calendar spreads constructed so that there is zero immediatedelivery of funds are basically the same as deliverable forward trades.No doubt an implied orderbook of these forwards could be constructedfrom the Forward Value Product internal matching spot market orderbook.These would then compete with FRAs to some considerable extent, at leastfor Pooled Deposit Product market members.

Introduction to the Enhanced Give Up Invention Description and Noveltyof this Part of the Invention

The thrust of all the inventions presented so far have been to broadenthe role of the traditional futures and options exchange trading andclearing venue in order to streamline the operations of the financialindustry. The first part of the invention sought to replace ISDA'scoordinating role with a truly central market in the main derivativeproducts traded by the market. The second part concerned supportinginnovations in the clearing house itself in order to achieve a moreefficient global coverage and greater accuracy in the product marginingand settlement. The third part of the invention concerned overhaulingand replacing the centuries old architecture of the interbank depositmarket.

To complete the picture we now look at incorporating genuine securitieswithin the traditional futures and options exchange trading and clearingvenue in order to complete this central provider of operational servicesacross the industry we envisage. The extent to which some of theseinnovations will be attractive to the market remains to be seen but theadvantages of having a single coherent system linking derivatives,structured products, traditional securities and interbank lending mustsurely be obvious from an operational and regulatory efficiency point ofview.

The Details of the Clearing House Securities Part of the Invention

Overview

A modern futures and options exchange is a highly efficient primarymarket in a certain subset of derivatives contracts. Because of thecentral counterparty services created by the exchange's clearing housethese derivatives contracts behave almost like securities. Howeverduring a give up there is genuine transfer of title and if paymentversus delivery methodology was introduced into this process a secondarymarket in ‘Clearing House Securities’ could be created. A genuinesecondary market would of course require a new trading platform to belinked into this modified give up process of a normal futures clearinghouse. The resulting central securities marketplace will be highlyoperationally efficient as it will already be deeply linked to thederivatives markets. For example this Clearing House Securitiesinvention allows for the securitisation of loans and hence theirefficient delivery into the Adapted For Exchange New Credit DerivativesRecovery Auction or Rate Product. Other applications include the entirerange of existing securities and in particular a rival issuance venuefor securities normally issued by special purpose vehicles such ascredit-linked notes and synthetic CDOs.

Advantages

The advantages of further operational consolidation are hopefully selfevident and include:

-   -   Cost savings; and    -   More efficient risk management; and    -   Greater ease of market monitoring for regulators, especially of        SPVs.

The above is not an exhaustive list. However the extent to which thispart of the invention is attractive to the market remains to be seen.

Clearing House Securities Issuance and Payment Versus Delivery for GiveUps

FIG. 22 shows this part of the invention schematically. In the preferredembodiment of the invention only the issuing member (see 2202 of FIG.22) acting on behalf of the issuing client (see 2200 of FIG. 22) hasaccess to the generation market of a Clearing House Security. Thissecurities generation market is just what was the normal market of thefutures and options exchange (see 2202 of FIG. 22). The open interest(see 2206 of FIG. 22) in the Clearing House Security is created by oneor more cross-transactions in the primary market (see 2202 of FIG. 22).

Having been created on securities generation market a primary issuance(or float) of the Clearing House Security occurs when the first paymentversus delivery ‘give ups’ occur via the new securities trading engine(see 2210 of FIG. 22) between the member acting for the issuer in thisforum (see 2208 of FIG. 22) and other members acting for their clients(see 2212 of FIG. 22). Technically the new securities secondary tradingexchange will look very similar to the existing tradition futures market(see FIG. 4) with access via exchange gateways and straight throughprocessing linked to the clearing house.

All trades in this market are only really modified give ups and onlyconcern long positions with the orphaned short position obligationsbeing passed by the issuing member directly to a specially createdaccount (or indeed membership) at the clearing house. The issuing member(see 2202 of FIG. 22) passes the cash created by the primary issuance tothe ultimate issuer (see 2200 of FIG. 22) for which it is acting asagent. The ultimate issuer retains the responsibility for servicing thepayments (e.g. coupons or dividends) of their Clearing House Securityand must make these payments directly to the clearing house according tothe legal terms underlying the security.

In the secondary market payment versus delivery ‘give ups’ also occurvia the securities trading marketplace created as part of the ClearingHouse Securities invention.

Securitisation and Stripping of Loans

Some market participants may not be able to take delivery of loans atthe expiry of an Adapted For Exchange New Credit Derivatives RecoveryAuction or Rate Product. This can be solved as already stated byrestricting participation in these products. An alternative is for theclearing house to act as a pass through intermediary:

-   -   The receiving long makes the cash payment to the clearing house        but receives not the loan but a series of cashflow clearing        house securities at zero price and of notional size and payment        dates corresponding to the loan repayment dates;    -   The short chooses to deliver the loan and the clearing house        takes delivery itself in return for passing through the cash        payment;    -   The cashflow clearing house securities remain marked to market        at zero price until clearing house receives a loan repayment        when it is obligated to take appropriate action i.e. if the        payment is made in full mark to market the relevant cashflow        clearing house securities to 100% and fund the variation margin        call from the obligation (short leg) to the float (long leg)        with the cash received from the loan repayment.

An interesting feature is that a secondary market can occur the momentthe cashflow clearing house securities have been created allowing for afully efficient secondary market in the entire loan or indeed instripped out components of it.

The Details of the Clearing House Special Purpose Vehicles ProxyInvention Overview

The example of securities loans can be generalised to include otherassets held at the clearing house. In particular this could include theentire range of existing securities and hence generating a rivalissuance venue for products normally issued by special purpose vehiclessuch as credit-linked notes and synthetic CDOs.

Special Purpose Vehicles, Credit-Linked Notes and Synthetic CDOs

Collateralised issuance can simply be performed by delivering theappropriate collateral to the clearing house which in return issues thefloat at zero price in order that it may be resold as a primaryissuance. This collateral could include cash; or treasury bills, notesor bonds; or even derivatives and clearing house securities contractsfrom the same exchange. In this way the clearing house can act as aspecial purpose vehicle and generate credit-linked notes, syntheticCDOs, etc., etc. As a trusted pillar of the financial system theexchange and its clearing house could also perform those supervisoryactivities normally undertaken by the trustees of SPVs.

1. A method of providing an operational robust interbank deposit andlending market based on an adapted electronic futures exchange typemarket model, rules and legal environment comprising: listing a listedfor trading product (the traded rate product) in an electronic futuresexchange type environment, which allows the borrowing or placement offunds; wherein the traded rate product volume is substantially theamount of money being borrowed or lent and so its notional lot size isthe smallest unit size of the currency in use; and the traded rateproduct quotation price used in front office systems appears inannualized percentage points according to the money market day countconvention; mapping the placed front office order quotation via analgorithm comprising a set of parameterized mapping formulae into arepresentation, the forward valued product, suitable for internalmatching and post trade clearing; reverse mapping from the forwardvalued product orderbook and fill information to traded rate productquotation orderbook and fill information; executing a trade relative tothe traded rate product quotation pursuant to a user command; deliveringforward valued product positions based on the executed order in exchangefor the transfer of funds associated with the traded rate product volumeafter a period of business days defining the spot date; and returningfunds plus interest at the expiration of the forward value productposition in cash currency equal to the forward value product positionsize held.
 2. The method according to claim 1, wherein the parameterizedmapping formulae of the algorithm used to turn the executed traded rateproduct quotation into the appropriate forward valued product contractsare comprise: for forward mapping:FVP Lot volume=TRP Lot volume*(100%+a*TRP Price %)IF TRP=Buy THEN FVP=Sell, ELSEIF TRP=Sell THEN FVP=BuyFVP Price=100%/(100%+a*TRP Price %), where, FVP=The relevant forwardvalued product expiry; TRP=The executed traded rate product quotation;and a=The money market accrual factor or year fraction that the numberof days between the spot date and the expiry date represent; and forreverse mapping:IF FVP=Buy THEN TRP=Sell, ELSEIF FVP=Sell THEN TRP=BuyTRP Price=(100%/FVP Price %−100%)/aTRP Lot volume=FVP Lot volume/(100%+a*TRP Price %), where, FVP=Therelevant forward valued product expiry; TRP=The executed traded rateproduct quotation; and a=The money market accrual factor or yearfraction that the number of days between the spot date and the expirydate represent.
 3. The method according to claim 1, wherein the forwardvalued products are not variation or initial margined and defaults arehandled by credit pooling in which the clearing house distributing anyshortfall in funds pro rata after netting, followed by the usual closingout or transfers of the defaulting member's positions.
 4. The methodaccording to claim 3, wherein a short grace period is provided in whichthe clearing house is permitted to make good the shortfall of fundswhilst charging a punitive interest rate to the responsible member. 5.The method according to claim 3, wherein the electronic futures exchangetype market model, rules and legal environment plus credit poolingeliminates the need for bilateral post trade confirmations that areneeded in traditional interbank lending and borrowing transactions, suchthat the exchange's execution systems can only match buy and sell ordersonce both counterparties to the trade have placed such orders in therelevant listed product, and the act of receiving a filled order reportfrom an exchange thus implies agreement on all product specificationdetails with the counterparty including the definition of product type.6. The method according to claim 3, wherein the relevant central bankfor the currency in question uses the adapted electronic futuresexchange to efficiently monitor the market and intervene at times of amember bank failure.
 7. The method according to claim 1, wherein dailymark to market reference prices in the traded rate product quotation aretransformed into daily mark to market reference prices in the variousforward valued product expiries by a method comprising:
 1. usinginterpolation to determine any missing daily mark to market referenceprices in the traded rate product quotation product that will berequired; and
 2. applying the formula:${FVP}_{i} = {{\frac{1}{1 + {a_{i}*{TRP}_{i}}}\quad{for}\quad i} = {{1\quad{to}\quad i} = m}}$where, FVP_(i)=The i^(th) forward valued product expiry; a_(i)=The moneymarket accrual factor or year fraction that the number of days betweenthe spot date and the i^(th) expiry represent; TRP_(i)=The i^(th) tradedrate product quotation expiry; and m=The expiry index corresponding tothe longest term traded rate product quotation product listed e.g. twoyears out.
 8. The method according to claim 7, wherein daily mark tomarket reference prices in the various forward valued product expiriesare used for variation margining.
 9. The method according to claim 1,wherein if initial margin is set by the clearing house for the variousforward valued product expiries this is done at levels established incooperation with the relevant central bank for the currency in question.10. The method according to claim 1, wherein the electronic futuresexchange type market provides, in addition to the listed traded rateproduct quotation spot curve for trading, additional listed for tradingforward curves.
 11. The method according to claim 10, whereindeliverable forward trades are listed at the traditional FRA liquiditypoints of 1×4, 2×5, 3×6, 4×7, 5×8 and 6×9 for three month forward termsand 1×7, 2×8, 3×9, 4×10, 5×11 and 6×12 for six month forward terms. 12.The method according to claim 1, wherein cash currency payments arecollateralized with securities thereby creating an efficient on exchangerepo market.
 13. The method according to claim 12, wherein if initialmargin is set by the clearing house for the various forward valued repoproduct expiries this is done at levels established in cooperation withthe relevant central bank for the currency in question, thereby creatingan official “hair-cut rate” policy setting tool.